When you buy clothing, it can be helpful to know the store’s return policy. When you book a trip, it can be helpful to know the hotel’s cancelation policy. Such policies help manage your expectations, and knowing in advance what to do if the clothing doesn’t fit or your plans change can provide much peace of mind.
It’s for those same reasons that all investors would benefit from a written document that describes why you’re investing, how you’re investing, and perhaps most importantly, what you will do — or not do — under challenging market conditions. In financial industry-speak, this is known as an investment policy statement.
If you don’t have such a document, right now — with the reemergence of volatility — would be a good time to draft one.
What to include
At a minimum, here are the essential elements of a good investment policy statement.
Current situation. How old are you, and if you’re married, how old is your spouse? What investment accounts do you have? How much money do you have invested across all accounts?
Goals. Why are you investing? What are you pursuing? Retirement? At what age? (Remember, while many of today’s workers say they’re planning to work past the traditional retirement age of 65, very few of today’s retirees actually did work that long. Many had to retire earlier than planned because of health issues, the need to care for a loved one, or a corporate downsizing. So, we recommend being conservative. That may mean intending to work as long as possible, but planning financially to retire around age 65-67.)
Contributions. Have you estimated how much you should invest each month in order to reach your goals? For a modest fee, Sound Mind Investing premium-level members have access to a very powerful tool, MoneyGuidePro®, that can help you figure this out. One very important take-away from this exercise is your assumed annual rate of return. We recommend being conservative here, and being realistic in choosing a number that’s in synch with your time frame.
If you’re also saving for college, perhaps through a 529 plan, we recommend using the aptly named World’s Simplest College Cost Calculator from Savingforcollege.com.
Write down how much you should be investing each month and how much you are investing.
Optimal asset allocation. If you haven’t taken SMI’s risk tolerance quiz (found in the Start Here section of our site), or if it’s been a while, why not take it right now? While you don’t need this information if you’re using Dynamic Asset Allocation, you do need it if you’re using Fund Upgrading or Just-the-Basics. As you get older, your optimal asset allocation will change. Going through a downturn might change your allocation as well.
Strategy. What strategy or strategies are you using and why did you choose them?
What if. Use this section to describe some of your core beliefs about investing — the opportunity the stock market offers, the futility of market predictions and market timing. And then write down how you will respond to extreme market conditions — hopefully that you won’t let a fast-growing market change your assumed annual rate of return or be disappointed that your portfolio may not be keeping up, and that you won’t let a falling market scare you off to the sidelines.
That last bit of guidance (what to do in response to a market decline) is especially important. It’s one thing to think about what you’ll do when the market turns lower; it’s another thing to write it down. So, give it some careful thought, talk it over with your spouse, and then put your commitments down on paper. Ideally, you won't make any changes in the face of significant market changes because you’ve been intentional about choosing a strategy you can live with in good times and bad.
Update your plan once a year. But feel free to look at it more often. Especially when the market gets a little wobbly, it can be helpful to remind yourself what your policy is for dealing with downturns.