You Need an Investor Policy Statement

I enjoy internet forums. I’ve been a lurker (non-participating reader) of several forums for quite a while. Since beginning to write, I’ve become a more active participant. I learn a lot when a question is raised and then answered by dozens of interested people with different backgrounds and perspectives. Crowdsourcing for a solution to any dilemma can be a great way to help you make a decision or simply become more educated on a topic of interest.

A frequent question that comes up on the forums I frequent looks something like this:

“Which is better, Small Cap Index Fund or Small Cap Value Fund?”

“I’m starting a Roth IRA. Should I use a Target Date Fund, a Total Stock Market Fund, or a Three-Fund Portfolio?”

“My 401(k) has expensive investment choices. Which of the following lousy funds should I have in my 401(k)?”

“I received a bonus/windfall of $10,000/$100,000/$1 million. How should I invest it?”

All of these questions, and hundreds of other similar questions that are posted on the internet every day, can be solved with the same exact answer:

“You need an investor policy statement.”

To answer any of these investment questions in isolation is problematic. The specific answer to the question proposed depends on a wide variety of factors that are rarely disclosed. I’d like to help, but I cannot responsibly tell you which fund(s) I think you should hold in a particular account without knowing what holdings you’ve got elsewhere, what your desired risk tolerance and asset allocation might be, how long your time horizon is, or what your goals are. If you don’t know these things yourself, we need to establish them first. This is where the Investor Policy Statement (IPS) comes into play.

What is an IPS?

An IPS is a list of your investing goals and strategies, incorporating your risk tolerance, desired asset allocation, and specific plans to achieve them.

Where can you get an IPS?

Here’s mine. If you want it, you can have it, although you will certainly need to change it to adapt it your own situation. A much better solution would be to create your own from scratch based on your life circumstances, goals, and risk tolerance.

The Physician On FIRE Investor Policy Statement

Objective:

• Retire early, no later than age 54/empty nest, most likely earlier.
• Acquire a large cushion, with > 40x annual expenses and > 50% available before 59.5.

Philosophy:

• Invest in a diverse portfolio of Vanguard Index Funds, keeping expenses low.
• Accept market returns, rebalancing with monthly investments.
• Risk tolerance quite high. Anticipate withdrawal rate < 3%.

Asset Allocation

• 60% US Stocks, 20% International, 10% REIT, 10% Bond / Cash.
• US stocks: Lean toward small and mid-cap value to maximize potential long-term return.
• International stocks: 50% Developed, 50% Emerging Markets.

Other Considerations:

• Maximize tax deductions via 401(k), 457(b), HSA, donor advised fund. Front load 457(b).
• Annual backdoor Roth contributions of $5,500 each (spouse and I) in January.
• Tax loss harvest when possible, which will require some attention to balances.
• Fund boys’ 529 accounts (each February and August).
• Invest in taxable account monthly.
• Forego monthly taxable deposits to cover large expenses (vehicles, home improvement).

Pre-retirement Considerations:

• Research health insurance options.
• Consider part-time work as an option to transition to retirement.
• Consider what’s best for the boys/family.

Drawdown Plan:

• Set up 457(b) to pay $1,000 to $2,000/month.
• Receive dividends and capital gains as cash transfers to bank account.
• When cash is needed, sell taxable assets and minimize/optimize capital gains.
• Attempt to remain in 15% tax bracket to avoid taxes on capital gains (unless tax laws change).
• Convert 401(k)/IRA to Roth as income/tax bracket allows.
• Donate appreciated securities to Donor-Advised Fund when needed to maintain low tax bracket.
• At 59.5, evaluate 401(k)/IRA and estimate RMDs, which kick in age 70.5.
• Anticipate delaying Social Security to get the maximum benefit, assuming good health.
• Pay for boys’ college with $2,000 to $4,000 cash (to obtain tax credits), then tap 529s.

Retirement Asset Allocation:

• 10 years of expenses in bonds (in 457[b] and 401[k]).
• Remainder in Equities, maintaining 3:1 US/International Ratio.
• Consider decreasing REIT holdings to 5%.

Why do I say you need an IPS?

That’s a fair question, and I’ll admit that need is a rather forceful word, but there are many benefits to creating an IPS. You can get by without one, but you really ought to have one. Here’s why:

• It defines your desired asset allocation. This is the keystone to a solid IPS, and if you don’t want to bother with creating an IPS document, you should at least start with a sensible asset allocation.
• It will force you to define your goals, and make a realistic plan to help you achieve them. In my experience, it’s way tougher to get somewhere if you don’t know where you’re going or what mode of transportation you’ll be using.
• It will make you less likely to jump from one investment to another. Investing with emotion and acting on recent performance data causes many a casual investor to chase returns, buy high, and sell low. These activities will decrease long-term returns and make reaching your goals more difficult and less likely to happen. Sticking with your IPS and updating it infrequently will help you “stay the course” and avoid costly mistakes.
• If you work with a financial advisor, creating an IPS together will ensure that your advisor understands your goals, and that he or she is helping you invest your money in a way that is consistent with your stated goals.
• While drafting an IPS, you can expect to learn more about investing, about yourself, and about how your goals can best be achieved, particularly if you are not initially well-versed in personal finance when you begin.

How do I get started?

Start with the basics. Determine your risk tolerance, and come up with a reasonable, preferably simple, asset allocation. Take some time to consider your goals. Talk with your significant other if you’ve got one. When you’ve got some goals figured out, write them down. Take time to understand the investment options available via the workplace and externally, and how to best utilize them to reach your goals. Your IPS can be much simpler than mine and could fit on an index card. The specifics can wait. You can make it as detailed as you like, of course, and I’ve seen some much longer than mine, too.

Where can I find additional resources?

The Bogleheads Wiki has examples and links to threads with many more examples.

The White Coat Investor has written a How To Guide on writing an IPS.

Google is a great starting point for the answer to just about anything, ever. This link is set up to search Google for you, so you don’t have to.

Take some time and come up with a simple investor policy statement. It doesn't have to detailed or complicated. It can even fit on an index card. A few guiding statements is much better than nothing at all.