Unlike a comprehensive financial plan which covers so many topics and can easily take an experienced professional many hours to create, an investment plan for a regular investor is relatively straightforward. This week I will give you some general guidance on how to create a simple investment plan for yourself. For people having someone managing their investments, it could also help you evaluate your current plan and see whether you are getting the knowledge and service you are paying for.
A written investment plan is technically called the Investment Policy Statement (IPS). It should become the foundation of your investment strategy and serve as a guide to the planning and implementation of it. Here below are the steps to create one investment plan and the components you should include in your IPS.
Step 1. Determine your investment, return, and risk objectives.
- Investment Goals
Write down your general investment goal like saving for a down payment of a house, generating additional income in retirement, etc.
- Return Requirements
Quantify your goal down to some specific numbers to get a defined overall performance objective. For example, a 5% compound annual growth rate is required to allow you to retire in 2030 based on your current financial plan.
- Risk Profile
Document your risk profile by taking into consideration your willingness to take risks, your ability to take risks, and the actual amount of risks you need to take in order to achieve your investment goal.
Step 2. Describe any relevant constraints
- Time Horizon
State how many years you have for investing in this goal since it is very important when determining a proper investment strategy. For example, you probably don't want to invest in stocks if you need the money to pay for your kid's college tuition in a couple of months.
- Tax Considerations
Identify any potential tax consequences when making investment decisions for this goal. Some type of investment gains may receive favorable tax treatments if they meet certain requirements. And the same investment can also receive different tax treatments when investing in the different type of accounts. For example, interests from municipal bonds can be tax-free if invested in a taxable account but could be taxable when investing in a retirement account.
- Liquidity Needs
Specify any liquidity needs you may have while investing. You need to make sure that those needs could be met by either liquidating some investments ahead of time or simply putting enough cash or cash equivalents aside.
- Legal/Regulatory Restrictions
Make sure that you are qualified to invest in the investments you choose. For example, certain investment programs may require you to be an "accredited investor" or even a "qualified purchaser" to participate.
- Unique Circumstances
List any additional and special criteria you may have when making investment decisions, such as investing solely in companies meeting certain environmental, social, and governance (ESG) standards, no use of leverage, and hedging foreign currency risks when investing in foreign investments, etc.
Step 3. Define your investment strategy.
Now you need to define an appropriate investment strategy based on the objectives and constraints you wrote down in the steps above.
There are many different investment philosophies with many more subsets of investment strategies under each philosophy. Besides, there are countless different ways to implement each specific investment strategy. For regular investors, my recommendation is that don't waste time on finding the best one because you can't. The more you know, the harder it would be. In the end, no one could predict the future. You should focus on what you can control instead，i.e. your financial goals, diversification, cost of investments, and your investing behavior.
I have my preference for sure when it comes to investment approaches. But I think the best investment strategy is always the one you understand and you could stick to for a long run. For those who are interested in my investment philosophy, you could learn the basics from here or read my blogs under the investment category for any specific topics.
Step 4. Establish processes and rules to implement and monitor your investment strategy.
This is a crucial step. You should explicitly define processes and rules regarding trading, performance measurement and evaluation, risk assessment, portfolio rebalancing, and even tax loss harvesting if necessary. For instance, buying or selling only when specific criteria are being met and rebalancing when deviating specific percentages from the target allocation, etc.
In my opinion, the biggest benefit of having a written investment plan is that it could be used as a policy guide preventing you from doing something emotional but not prudent during periods of market turmoil. Regardless of your investment strategy, stay disciplined and avoid making investing behavior mistakes. That is one of the most important things you could do to get a better investment experience.
Step 5. Assign responsibilities and hold yourself accountable.
Last but not least, you should assign the responsibility of creating, implementing, monitoring and reporting to someone who is capable and trustworthy and let a different person held him/her accountable. I understand that it can be difficult if you manage your investments by yourself. But it is not something cannot be done. For example, you could assign all the responsibilities to yourself, give the IPS to your significant other, and ask him/her to hold yourself accountable. For people who have someone managing investment for them, you should hold the professional accountable based on the IPS he/she created for you. In the end, no matter how great an investment plan you have, it is worth nothing if you do not follow it.
A written Investment plan or an Investment Policy Statement (IPS) is not a regulatory requirement in the industry. Many financial advisors do not provide it to their clients. However, like a comprehensive financial plan, I highly recommend everyone have one or even one for each investment goals you have. A well-written IPS could provide you the guidance you need and give you a piece of mind when you face a situation and don't what to do with your investments next time.
One last thing worth mentioning here is that for people who are using robo-advisors like Wealthfront or Betterment, you have probably realized that you do not get a written investment plan to follow. Their default process of identifying your objectives and constraints is also very simple and limited. I recommend you go through the process mentioned above, create your IPS, and only treat the robo-advisor as an investment strategy with some portfolio management responsibilities. It won't surprise me at all if some of you find out that you need to adjust the portfolio initially recommended by the robo-advisor based on the IPS you just created.