It's the real secret to successful investing.
By Sue Stevens, CFA, CFP, CPA | 08-15-02 | 06:00 AM | Email Article

Do you want to know the real secret to successful investing? It's a deceptively simple little thing called an Investment Policy Statement, or IPS. An IPS spells out an investor’s investment philosophy, asset-allocation targets, and expected results. It also lays out a plan for how the investor will monitor his or her portfolio. 

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Big organizations create IPSs for their company retirement plans. Financial advisors craft them for their high-net-worth clients. You need one, too. Why? Because the IPS forces you to put your investment strategy in writing and commit to a disciplined investment plan. 

Here’s what you should include in your IPS, and a sample you can imitate. This is a purely a hypothetical situation and person--let's call her Nanci. You need to substitute your own goals, investment-selection criteria, and expected outcomes. 

Executive Summary
The important elements of your IPS--your current assets, time horizon, required return, tolerable losses, and portfolio benchmarks--appear at the start in a summary format. You’ll come back to your Executive Summary when you rebalance your portfolio. 

Here is Nanci’s summary. 

Current Assets: Nanci has a total of $1,000,000 in assets. 

Time Horizon: With 16 yearsto retirement and an expected 30 years in retirement, Nanci has a 46-year time horizon. 

Overall Portfolio Expected Annual Return: Nanci expects a portfolio return that is 4.5 percentage points over inflation. 

Calculating your expected return can be tricky. I suggest that you come up with a return figure in excess of inflation. Inflation will vary over time, but it’s the incremental return over inflation that's most important in meeting your goals. Don’t worry about trying to make any predictions about future inflation rates. Do think about what is reasonable to expect as an incremental return over and above inflation. 

As a guideline, here are the real annual returns (not including inflation) that I use: 

  • Large-cap U.S. stocks: 5.5%          
  • Mid/small-cap U.S. stocks: 6.5%          
  • International stocks: 6.0%          
  • Bonds: 3.0%

If you have a balanced portfolio, you'll have a blend of these returns based on your asset allocation mix. If you are very conservative, choose numbers below our estimates. Conversely, if you are aggressive, adjust the numbers upward. 

Loss Limit: Nanci could accept losing 15% in any single year. Over a five-year period, she could lose 3% annualized. 

This figure is the most you expect to lose over a specified time period given your tolerance for risk. So in this case, Nanci knows that she could lose 15% in any one year, and she's willing to accept that level of risk. Over a five-year period, she knows that she could lose 3%. If her portfolio fell by more than that, she'd have to re-examine her securities to see how she could cut back on her riskier holdings. Investors need to balance taking on risk in order to meet their goals with taking on too much risk and losing more than they can afford to. 

Asset Allocation: Nanci has set the following lower limits, targets, and upper limits for investment in each asset class.  

 Nanci's Asset Allocation
Lower Limit
( % )
( % )
Upper Limit
( % )
Large-cap value stocks
Large-cap growth stocks
Mid/small-cap stocks
International stocks

Rebalance when your portfolio exceeds the upper or lower limits. 

Evaluation Benchmarks: For evaluation, Nanci will compare the total return of each security to its category and expect it to be in the top 33% of its category over three and five years. She'll also ask whethershe is able to reach her goals. 

Even if your investments fall short of your benchmarks, you may not want to sell them if they’re still getting you to your goals. For example, take a look at T. Rowe Price Science and Technology . In 1999, the fund returned 101% but ranked in the specialty-technology category’s 73rd percentile. If that performance is enough to get you to your goal, you may not want to sell, even if most of the category is outperforming your fund or stock. It's really a matter of judgment. 

Here’s where you state your goals. What are you trying to accomplish, and in what time frame? Seeing your objectives in writing makes a lasting impact. And it comes in handy when it's time to rebalance. If you have multiple goals, here's the place to prioritize those objectives. 

Here are Nanci's objectives.  

  1. To retire in 16 years.          
  2. To be able to spend $100,000 per year, pretax, during retirement.          
  3. To make her assets last the rest of her lifetime.

Investment Philosophy
Jot down the basic investment theories that you believe in and plan to follow. Consider your ability to take risk, your plan to balance risk and return, and any other principles you consider important to your long-term strategy. 

Here is Nanci's approach to investing. 

  1. Nanci will balance taking as much risk as she possibly can to achieve a higher long-term rate of return with her ability to tolerate that risk and not panic in a downturn, selling at the wrong time.          
  2. Recognizing that she will never know which asset class will outperform each year, Nanci will diversify across a wide range of investment opportunities. Then she can participate in the upside of most asset-class performance without over-concentrating in one area and risking a loss that she can't tolerate.          
  3. She will control costs by limiting expense ratios, 12b-1 fees, loads, brokerage costs, and advisor's fees.

Preferences and Constraints
Every investor has unique circumstances that influence their investment decisions. Write down any that apply to you. 

Nanci’s preferences and constraints: 

Time Horizon: Nanci has a long time horizon--more than 10 years. She can afford to tolerate short-term market fluctuations.  

Asset-Class Preference: Nanci believes in the fundamental concept of allocating her assets over a variety of sub-asset allocation categories. Her preference is to include large-cap value stocks, large-cap growth stocks, mid/small-cap stocks, international stocks, bonds, and cash. She chooses not to use emerging-markets funds or most sector funds because she thinks their risks are more than she can tolerate.  

Performance Expectations: Nanci's goal is to beat inflation by 4.5% annually on an overall basis.  

Tax Issues: Nanci has significant capital gains (an amount that could push her into the next highest marginal tax bracket) in her taxable accounts. To avoid an unduly high tax bill in any one year, if she decides to sell out of a significant position, she will strongly consider doing this over a period of time. 

Risk Tolerance: Given that Nanci has a long time horizon, she is willing to tolerate short-term market fluctuations of up to a 15% loss in any one year. She wouldn't want to lose more than 3% over any five-year period, though.

As I mentioned above in the Executive Summary, if her portfolio fell by more than 15% in one year or 3% in five years, she'd have to re-examine her securities to see how she could cut back on the riskier holdings. 

Asset Allocation Limits: Nanci plans to always have at least 5% in cash, but never more than 10%. She would never want to have more than 40% of her assets in mid/small-cap stocks nor more than 30% in international stocks. Further, she’d never want to have less than 40% of her assets in large-cap stocks. She would never want the combination of cash and bonds to be more than 75% of her portfolio.

These limits represent how much risk Nanci is willing to take with her overall portfolio. Every asset class has an associated level of risk and expected return. The amount of assets you put in each category depends on how much volatility you can tolerate.

Investment Selection Criteria
Everyone should consider how they pick their investments. There are practically an unlimited number of screens you can run with tools like Morningstar's Stock and Fund Selectors. Be sure to document your criteria in your IPS. 

Nanci's investments must meet the following criteria: 

True No-Load Funds Only: Funds with any type of front load or 12b-1 fees will be eliminated. 

Performance Consistency: All core funds must have consistently performed in the top one third of their category for five years.

(To learn more about core funds, read "The Rock-Hard Heart of Your Portfolio".)  

Expenses: Large-cap funds cannot have an expense ratio greater than 1%. Small- and mid-cap funds cannot have an expense ratio greater than 1.25%. International funds cannot have an expense ratio greater than 1.5%. Bond funds (other than high-yield bond funds) cannot have an expense ratio greater than 0.5%. High-yield bond funds cannot have an expense ratio greater than 0.75%.

Nanci established these limits by finding the average expense ratio in each category and then adjusting up or down depending on the pool of available high-quality funds.  

Style Purity: Foreign funds cannot have more than 10% of their assets in U.S. stocks.  

Qualitative Factors: The pool of funds and stocks that meet the above criteria will then be ranked highest to lowest by category rating. As a final screen, Nanci will look beyond the numbers to qualitative factors. She will get the "Morningstar Take" from the Morningstar Analyst Reports, read the "Recent News" and "Recent Conversations" from the Quicktake links, and visit the fund’s or company’s Web site to see what more she can learn.  

6. Monitoring Procedures
This section of the IPS is your blueprint of what to look at when you are rebalancing your portfolio. It forces you to think through your watch list and sell criteria.  

Here are Nanci’s monitoring procedures:  

Although Nanci will review her portfolio performance on a quarterly basis, she will not make sell decisions more often than annually. At that time, she will not only review the returns of each of her investments against their peer groups, but she'll determine whether these investments are edging her towards her goals.  

Here are the questions Nanci will ask about each investment:  

  • Has the allocation to the investment changed by more than the upper or lower boundaries outlined above? If so, consider selling some of the gains (and perhaps netting out some losses), or rebalancing within tax-deferred accounts.          
  • Did the overall portfolio beat inflation by 4.5%? If not, what changes are necessary to meet this criterion? Are performance expectations reasonable?          
  • Are there any changes to make due to a shortened time horizon?          
  • Were there losses in the portfolio? Were overall portfolio losses within the loss limits specified above? If not, which individual securities were responsible for the overall losses? Has anything fundamentally changed for these securities? Do we want to make a change?          
  • Are the securities in the top one third of their peer groups? If not, they should go on a watch list. It's not time to sell, but keep a close eye on future developments. If the security is on the watch list for more than two or three years, see if it is still meeting the long-term goals. If not, it's time to sell. (If it's in a taxable account, try to balance losses with gains.)

If a sale is contemplated, Nanci will ask the following questions: 

  • Is the investment preventing me from achieving my goals?           
  • Are the tax impacts of selling outweighed by the opportunities of a new investment?

Nanci will also set up ongoing electronic alerts for the following: manager change, category-rating change, and expense-ratio change. She can do this at Morningstar's Portfolio Manager.  

Now It's Your Turn
Use Nanci's IPS as a guideline. Fill in your own expectations and criteria. Date it, sign it, and come back to it in a year. It’s the framework for analyzing your portfolio's performance--and for whether you’re progressing as you should toward achieving your dreams.

This article originally appeared on September 21, 2000.

Securities mentioned in this article



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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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