The market is down. You’re scared. You hate losing money even more than you enjoy making it. Do you remember what you told yourself to do?
You told yourself that you wouldn’t sell. That you would invest 20% of every paycheck. That you would buy index funds and avoid chasing stock “advice”.
Did you do what you told yourself to do?
Financial advisors create a formal Investment Policy Statement with each client as an upfront agreement on how they will be invested. But an investment policy statement isn’t just a useful tool for advisors. Do-it-yourself investors should have a written policy of their own. A letter to their future selves—written by their calm and rational selves—that says exactly what they should do when they’re afraid, anxious, or excited, and tempted to deviate from the plan.
Why you need an investment policy statement
When it comes to investing, you can be your own worst enemy.
According to one well-known study, the average stock market investor returns 3% less per year than if they simply bought and held an S&P 500 index fund. That leaves them with 1.5 times less money after 30 years than the person who just stuck it in an index fund!
The reason most investors underperform the market, even when they’re just trying to match it with index funds, is because it’s easy to get caught up in emotion and feel like you should be doing something to make your investments perform.
You panic sell when the market drops and don’t get back in until it has fully recovered. You sell when the market is at an all-time high and miss out when it keeps going up (the market averages 16 all-time highs per year!). Then you get caught up in market euphoria and put all of your money in just before the bubble pops.
The fact is, the stock market is the only place where the more work you do the worse results you get.
Fidelity studied thousands of accounts over a 10-year period and hilariously found, according to this article, that the best performance came from investors who were either dead or had forgotten about an account from a former employer!
Those are the most foolproof ways to protect yourself from yourself. But they aren’t too practical. You want to access that money eventually, so don’t forget about it. Do the next best thing and commit to keeping your hands off it.
Stop looking at the market and listening to the financial media if you have to. Delete the brokerage app from your phone. Don’t save your password so you’ll have to reset it to get in. And force yourself to read your investment policy statement before you make any investment decision.
If it isn’t in the policy, you don’t do it. Simple as that.
What a great investment policy statement looks like
A great investment policy statement isn’t long or complicated. It just needs to have a few key pieces of information in it that describe your high-level plan for investing:
- Investment objective – What are you investing for? Retirement in a certain year? Getting to a specific net worth? This keeps you focused on the prize.
- Target asset allocation – This is the portfolio you want to hold long-term. Don’t mention specific stocks or funds. Keep it high level so you can change investments at a low level—to lower fees or because the funds offered by your 401k changed, for example—without requiring a policy change.
This allocation shouldn’t change unless (a) your objective changes or (b) you move into a new financial stage, for example, from the Ascent to the Summit of financial independence. The Policy Changes section below describes when and how changes will be made.
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- Rebalancing plan – How often do you want to rebalance your portfolio to bring it back to its target allocation? How far will you let it deviate from the target contribution before you rebalance it? Typical recommendations are annual rebalancing and letting the allocation vary by at least 5% before pulling it back in.
- Contribution plan – What types of accounts will you use, and in what order? Read Put Your Retirement Savings in These Accounts First for my thoughts. Is there a percentage of your income or your paycheck that you are committed to invest?
- When to buy – Will you buy at regular intervals? As frequently as you get paid? Max out your Roth IRA on the 2nd of January and invest it on the 3rd? Do you have rules that will cause you to buy more or less of something?
- When to sell – What are your rules for selling an investment? Will you buy and hold until needed for retirement income? Will you sell a portion when you meet a nearer-term goal such as a house down payment? Are there any other conditions that will trigger you to sell?
- Policy changes – It’s important to review the policy occasionally. This will help you remember what it says. And it will make sure that the plan still suits your needs, for instance, if a big life change has occurred and your objectives are different than before.
How often will you look at the plan to make sure it still aligns with your goals and needs? What process will you go through to make changes to this plan? Will you make changes independently? Or do changes need approval from a spouse or advisor?
Here’s an example of what my investment policy statement looked like while I was on the Ascent stage of my financial journey.
Example Investment Policy Statement
- Investment objective – Financially independent by age 35 with $2.5 million investable assets.
- Target asset allocation – 45% large cap, 30% small cap, 25% international stocks. Invested in low-cost index funds. If the account doesn’t offer an index, the closest alternative will be used.
- Rebalancing plan – Rebalance once per year if any position is ±5% or more from its target allocation. Keep balance by tilting new contributions toward out-of-balance positions.
- Contribution plan – Max out 401k, Roth IRA, and HSA annually. Invest any additional savings in a brokerage each pay period. Invest at least 30% of income with a target of 50%.
- When to buy – I will invest according to my target asset allocation every pay period, and as soon as new money becomes available. Automation will be used as much as possible, including automatic reinvestment of dividends.
- When to sell – I will not sell investments until they are needed for income during retirement. The only exception to this is in the unlikely event that an emergency occurs, my emergency fund is depleted, and there is no other way to cover the expense. In that case, I will use brokerage funds first, and then Roth IRA contributions as a last resort.
- Policy changes – This plan will be re-evaluated annually, at the same time the portfolio is rebalanced, to make sure that goals and objectives have not changed. If a change to this Investment Policy Statement is required, the change must be agreed upon by both spouses.
You can compare this to a financial advisor’s example investment policy statement if interested. As a DIY investor, I find the simple example above to be more useful.
How to use your investment policy statement
Now that you have a written investment policy statement, you need to make sure that it gets followed. Otherwise, there was no point in writing it!
You might want to print it out and put it on your bathroom mirror, the side of your refrigerator, or somewhere that you can refer to it often for the first few months. Or you can set a reminder on your phone to re-read it periodically until it becomes part of your investing nature.
Then, whenever you’re tempted to look into a new investment that someone just told you about or to make a trade when the market is making big moves, refer to it before any decisions are made. This is the most important part of the process! If the idea you had or the action you want to take is not allowed by your investment policy statement, don’t do it!
Maybe it’s a small move that won’t have a large impact on your investment performance either way. If your policy allows it, then go ahead.
There might come a time when you learn something from a book or advisor that really should be a part of your plan. A better way of doing things. Don’t change your policy immediately.
Think about it for a few days or weeks first. Get a second opinion from someone you trust. Wait until the initial excitement of finding a “great new way” of investing wears off. Then, if it still seems like the right thing to do, make the change.
Summary
Everyone should go through the process of creating a personal investment policy statement.
Whether you document it or not, you already have one. If it’s just in your head, it might be missing a key element that would keep you out of trouble if you thought it through. And you might not follow it well; but it’s there. Write it down to make sure that it’s really what you want to be doing with your life savings!
Use the template above, and add to it if there’s something else that you find important to include.
Then make sure to follow it. And keep it in mind whenever you touch your investments. It’s there to save you from yourself. Because emotions are a powerful thing, and humans have proven over and over that emotions can cause them to make poor decisions.
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