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The power of an Investment Policy Statement

Mark LaMonica, CFA  |  14 Jan 2021Text size  Decrease  Increase  |  
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Mike Tyson famously said that everyone has a plan until they get hit in the face. As investors the proverbial punch in the face are market downturns—and most of us take that punch without even having a plan to fall back on. In our first two pieces of the year we covered the importance of goals and using our goals to calculate a required rate of return and subsequently to make asset allocation decisions. These are the foundations needed to be a successful investor. However, there is one last piece of the puzzle which is the plan for how you will manage your portfolio going forward.

Investment policy statements are often used by portfolio managers and financial advisers, but they are also helpful for individual investors. An investment policy statement is simply documentation of the parameters of your investment plan. It includes the asset allocation framework, criteria for selecting securities and the process you will go through to maintain those investments.

The benefits of this approach are plentiful. Writing down a plan makes it more likely that you will accomplish it. If you will forgive a brief and completely unqualified foray into neuroscience, there are two benefits to writing things down: external memory and encoding. External memory simply means that you will remember something better if there is a visual cue. Encoding is how your brain chooses to remember certain things and discard certain things. Writing it down means there is a much better chance that you will remember it.

We can look at two key issues that investors face and show how an investment policy statement can improve investor outcomes. The first issue is over trading. Over trading leads to bad outcomes like transaction costs and taxes. It also can indicate that you are chasing performance. Getting into a hot stock, fund or ETF may seem like a good idea but assumes that outperformance will continue and you haven’t missed the boat on the gains. Studies show us this isn’t the case. An investment policy statement can act as a speed bump that outlines the criteria for why you would buy an investment and why you would sell an investment. It is likely that adhering to your pre-established criteria will limit your trading and chasing of returns.

At the opposite end of the spectrum is a problem that I reluctantly admit that I suffer from. My name is Mark LaMonica….and I am an investment collector. I spend my days reading about the dangers of over trading and chasing performance. Consequently, I don’t like to sell investments—ever. Adding to my affliction is my intense focus on price which often prevents me from building a meaningful enough position if prices start to rise. I own too many securities and some of them make up too small of a percentage of my portfolio to have any real impact on it. Once again, defining the criteria for the number of holdings in a portfolio, the percentage of the portfolio that any new position needs to make up and the criteria for selling can help.

Read the article on the three steps to creating an investment policy statement to see the steps needed to create your own. These steps should occur after you have established your goals and selected your asset allocation target. If you are still struggling with that step you can listen to our podcast How to Construct an Investment Portfolio for a real-life example.

Resources to assist:

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is a product manager, individual investor, Australia.

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