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[Prefer to listen? You can find a podcast version of this article here: E169: What is an Investment Policy Statement?]

Investing is personal. It’s rarely a one-size-fits-all approach. While there are certainly general guidelines and models available, it’s important to understand what factors are important to you when putting a plan together.

When putting together an investment plan on your own or with a financial advisor, it’s important to establish a set of guidelines that define your approach. If you’re DIYing it, you can put it together in a simple document. If you’re working with a financial advisor, they likely have a more formal structure but there is no right or wrong.

The important thing is to outline the facts of your financial life, your goals for the investment(s), and your comfort level with risk as well as your overall capacity for risk.

So what is usually contained in an Investment Policy Statement?

What’s in It

While there is no one established standard for an Investment Policy Statement (or "IPS"), it should generally describe the facts needed to properly determine the appropriate asset allocation for the investor.

This includes age but also includes things like how soon you plan to use the money you are investing. Three years? Five years? Ten years or more? Retirement? This is your risk capacity.

On the subjective side, it is likely to include some sort of assessment of your tolerance for risk and volatility. This is hard to measure accurately. However, it’s useful to do the best you can to create some sort of metric that demonstrates how you will feel if your account value drops 20% in the short term.

If you’re working with a financial advisor, this will be built into the tools they use. If you want to do it on your own, there are a few basic ones available here (no affiliation or endorsement implied):

• Vanguard Risk Assessment
• Schwab Risk Assessment

These factors all help you determine what a suitable approach might be for your investment plan.

Once this information is determined, it can guide your asset allocation. Your asset allocation is the “mix” of your investments. The two primary asset classes in most portfolios are equities (stocks) and fixed income (bonds). However, other asset classes can be used, including emerging markets, commodities, precious metals, real estate, and other alternative investments.

As a general rule, the more stocks you have, the more aggressive the portfolio is. The more bonds you have, the more conservative it is. "Aggressive" in this case means more susceptible to volatility (significant ups and downs in value). Conservative means a smoother path and less volatility.

How is it Used?

So how do you use an Investment Policy Statement? Great question. The IPS serves more than one purpose. If you’re working with a financial advisor, one purpose it serves is to establish an agreement with them. As financial advisors, our goal is to provide the best advice and management possible for your situation, and creating an IPS helps establish guidelines that both parties agree on. As your financial advisor manages your investments, the IPS serves as a blueprint for them to follow and make sure that all decisions follow the guidelines established.

The Investment Policy Statement is also a great tool for you to use as a reference point. For most people, the plan is a long-term investment. This means that it is often acceptable to anticipate short-term volatility knowing that future returns are the goal. However, a drop in the market or a talking head on the news screaming about the stock market can cause some people to get scared and make irrational decisions (it can happen to all of us). The IPS is designed to remind you of your goals and to help you “stay the course” even if you feel anxiety over short-term events.

How Often Should You Update the IPS?

I recommend updating your Investment Policy Statement annually, although it can sometimes make sense to update it more often if you have significant events in your life, such as job loss or change, relocation or buying a home, change in expenses, medical event, marriage, kids, starting a business, change in income, etc.

Single or as a Couple?

In a marriage or committed relationship, should an Investment Policy Statement apply to each person individually or to the couple collectively?

My stance is, the IPS should be unique to each person, but the financial facts can be entered as combined information if the partners operate with combined finances. So if you and your partner live together and combine your household finances, the financial data (net worth, income, etc.) would be entered as combined numbers into each IPS.

If each person in the relationship operates financially independently and finances are not combined, then data would be entered as individuals.

If it’s a hybrid situation then it likely warrants a conversation between partners or with a financial advisor to see what approach makes the most sense.

Even if the data is entered as a couple, I still like to assign portfolio composition individually so that each person’s preferences are honored. If one person is comfortable with volatility and the other is not but all the accounts are tilted aggressively, that is likely to cause stress for one partner. Since IRAs (the most common account type) are individual accounts, each person gets to honor their preferences.

What about joint accounts? I generally choose an investment mix that fits into the ranges of both partners or sometimes even set up two joint accounts so we can use both to honor each partner’s risk tilt.

The Bottom Line

So how necessary is an Investment Policy Statement? While it’s not mission-critical, it does provide a valuable framework that can make larger impacts as time goes on. In serving the purpose of creating guidelines for both you and your financial advisor for investing, I would not underestimate the value it can have.

I would venture to say that it can even bring peace of mind, which is hard to put a price on.