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Course 108
Creating Your Investment Policy Statement

Introduction

Big organizations create them for their company retirement plans. Financial advisors craft them for their clients. They require some philosophizing and number crunching. And when done thoughtfully and comprehensively, they can be 15 pages long.

What are "they"? Investment Policy Statements, or IPSs.

An IPS isn't only for the well-heeled who love paperwork. It's a must for all investors. That's because creating an Investment Policy Statement forces you to put your investment strategy in writing and commit to a disciplined investment plan. It's both a blueprint and a report card.

We can't cover everything that you'll need to include in your Investment Policy Statement in just one class. But by downloading, printing, and filling in Morningstar's Investment Policy Statement Worksheet, you'll have a good start. Download the worksheet here. (Note: The worksheet is available as a PDF file. You will need Adobe® Acrobat® Reader to view and print it.)

If you've been taking classes in the Portfolios Track of the Investing Classroom in order, you'll already know the answers to many of the questions that the Investment Policy Statement includes. Don't worry if you haven't taken previous classes, though. We'll tell you which classes you'll need to review to answer these questions.

Executive Summary

The Executive Summary provides an overview of your current situation and what you expect from your portfolio. It's a snapshot in time. Update your Executive Summary whenever you rebalance your portfolio.

Here are the questions to answer:

  • What are the current assets of my portfolio today?
  • How much do I plan to invest each month?
  • How many years will I be investing?
  • How much do I expect my portfolio to return each year over inflation?
  • How much of a loss can I accept over a three-month period, a one-year period, and a five-year period?
  • What is my target asset allocation?
  • What are my benchmarks for my portfolio?
To help you answer the first six questions, review the following classes:

Portfolios 103: How Much Risk Can You Tolerate?

Portfolios 105: Determining Your Asset Mix

When it comes to answering the final question, choose your benchmarks wisely. Say you have a portfolio that's 40% invested in U.S. large-company stocks, 10% in U.S. small-company stocks, 30% in bonds, and 10% in foreign stocks. Don't use the S&P 500 as your portfolio's benchmark. It's inappropriate. After all, the S&P 500 is made up strictly of U.S. large-company stocks. The S&P 500 may be a suitable benchmark for the 40% of your portfolio that's comprised of U.S. large-company stocks, but not for your entire portfolio.

In most cases, you'll need to use a combination of benchmarks to measure the success of your portfolio as a whole and the success of your individual investments.

You'll also need to decide over what time periods you want to benchmark your portfolio and your investments. Do you want to benchmark your portfolio's annual returns? Its three- or five-year returns? Some combination thereof? We recommend keeping abreast of your returns yearly, but focusing mostly on longer-term results.

Investment Objectives

The Investment Objectives portion of your Investment Policy Statement details what you're trying to achieve with this portfolio and in what time frame.

Answer the following questions:

  • What is my financial goal?
  • How long will I be funding this goal?
  • How much will this goal cost every year?
To help you answer these questions, review Portfolios 102: Determining Your Goals and What They'll Cost.

Investment Philosophy

In the Investment Philosophy section of your Investment Policy Statement, you'll articulate what's important to you as an investor. These are the theories you believe in and plan to follow.

Here are just a few questions to consider:

  • What's my philosophy about risk?
  • What's my philosophy about core versus noncore investments?
  • What's my philosophy about diversification?
  • What's my philosophy about trading?
  • What's my philosophy about costs?
  • What's my philosophy about taxes?
Before you buy or sell any securities, make sure that your actions reflect your philosophy. If they don't, ask why. Maybe you shouldn't be buying or selling that security. Perhaps your action is based on short-term performance, or a hunch about what the market is going to do. But your actions should be based on your Investment Philosophy.

Investment Selection Criteria

The Investment Selection Criteria section of your Investment Policy Statement includes your rules for choosing investments. These rules will vary significantly from investor to investor, based on each investor's Investment Philosophy. Think of these criteria as a means of quantifying your philosophy.

To determine what qualities an investment must have before joining your portfolio, consider reviewing some of the classes in the Mutual Funds and Stocks tracks of the Investing Classroom.

Some criteria to consider for mutual funds:

  • Minimum category rating
  • Minimum total return % category rank over various periods
  • Maximum bear-market rank
  • Maximum percentage of assets in top-10 holdings
  • Maximum percentage of assets in any one sector
  • Maximum expense ratio
  • Minimum or maximum asset size
  • Minimum manager tenure
  • Minimum tax-efficiency ratio
Some criteria to consider for stocks:

  • Maximum price for each stock
  • Minimum return on equity
  • Minimum free cash flow
  • Minimum forecasted five-year earnings-growth rate
  • Maximum leverage
  • Minimum dividend yield
  • Minimum market capitalization
  • Maximum price/earnings ratio
  • Minimum revenue growth rate
Any new investment that you're considering for your portfolio should meet these criteria. If it doesn't, why not? Do your criteria need to be altered? Or is this an investment that you shouldn't make given your philosophy?

Monitoring Procedures

The Monitoring Procedures portion of your Investment Policy Statement details your plan for keeping tabs on your investments. It's your blueprint for rebalancing, and for determining what investments, if any, you should sell.

Answer the following questions:

  • How often will I monitor my portfolio?
  • How will I determine how well my individual investments are doing?
  • How will I determine how well my overall portfolio is doing?
  • How will I determine if my portfolio is meeting my expected return?
  • How will I determine whether losses fall within my accepted range?
To determine how well your individual investments and overall portfolio are doing, be sure to use the benchmarks you chose in the Executive Summary section of the Investment Policy Statement. If you find that your portfolio is not meeting your expected return, or that losses are falling outside of an acceptable range, you may need to adjust your investments.

When monitoring, don't focus only on performance, though. Make sure the reasons you chose these investments in the first place still apply. To do that, check the status of each investment against your Investment Selection Criteria. If a stock or fund no longer meets your criteria, it may be a sell candidate.

For more about portfolio monitoring, skip ahead to Portfolios 301: How to Monitor Your Portfolio and Mutual Funds and Portfolios 302: How to Monitor Your Stocks.

Revisiting Your IPS

Once you've created your IPS, sign it, date it, and come back to it in a year. The Investment Policy Statement isn't only your investing blueprint. It's also your portfolio's report card.

Quiz 108
There is only one correct answer to each question.

1 What does the Executive Summary portion of the IPS do?
a. It summarizes your current situation and what you expect from your portfolio.
b. It lays our your rules for buying investments.
c. It lays out your rules for selling investments.
2 What benchmark is most appropriate for a portfolio that is 50% invested in U.S. large-company stocks, 25% in bonds, and 25% in foreign stocks?
a. The S&P 500
b. A bond index
c. A customized benchmark that combines U.S. large-company, bond, and foreign-stock indexes
3 Investment Selection Criteria are...
a. Only rules for choosing investments.
b. Only criteria to use when monitoring your investments.
c. Both a and b.
4 When buying or selling securities...
a. Your actions should reflect your Investment Philosophy.
b. You should focus on short-term performance.
c. You should be trying to guess where the market is going.
5 The IPS is...
a. Your investing blueprint.
b. Your portfolio's report card.
c. Both a and b.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
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