Investing Classroom: Creating your 'IPS'

Big organisations create them for their company retirement plans, financial advisers craft them for their clients, they require some philosophising 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 lesson 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 reading our previous portfolio lessons, you'll already know the answers to many of the questions that the Investment Policy Statement includes.

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:

1. What are the current assets of my portfolio today?

2. How much do I plan to invest each month?

3. How many years will I be investing?

4. How much do I expect my portfolio to return each year over inflation?

5. How much of a loss can I accept over a three-month period, a one-year period, and a five-year period?

6. What is my target asset allocation?

7. What are my benchmarks for my portfolio?

To help you answer the first six questions, review this earlier lesson: Portfolio lesson 1.3: How much risk can you tolerate?

When it comes to answering the final question, choose your benchmarks wisely. Say you have a portfolio that's 40% invested in UK large-company stocks, 10% in UK small-company stocks, 30% in bonds, and 10% in foreign stocks. Don't use the FTSE 100 index as your portfolio's benchmark. It's inappropriate. After all, the FTSE 100 is made up strictly of UK large-company stocks. It may be a suitable benchmark for the 40% of your portfolio that's comprised of UK 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:

1. What is my financial goal?

2. How long will I be funding this goal?

3. How much will this goal cost every year?

To help you answer these questions, review Portfolio lesson 1.2: Determining your goals.

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:

1. What's my philosophy about risk?

2. What's my philosophy about core versus noncore investments?

3. What's my philosophy about diversification?

4. What's my philosophy about trading?

5. What's my philosophy about costs?

6. 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 Stocks tracks of the Investing Classroom.

Some criteria to consider for funds:

1. Minimum category rating

2. Minimum total return % category rank over various periods

3. Maximum bear-market rank

4. Maximum percentage of assets in top-10 holdings

5. Maximum percentage of assets in any one sector

6. Maximum expense ratio

7. Minimum or maximum asset size

8. Minimum manager tenure

9. Minimum tax-efficiency ratio

Some criteria to consider for stocks:

1. Maximum price for each stock

2. Minimum return on equity

3. Minimum free cash flow

4. Minimum forecasted five-year earnings-growth rate

5. Maximum leverage

6. Minimum dividend yield

7. Minimum market capitalisation

8. Maximum price/earnings ratio

9. 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:

1. How often will I monitor my portfolio?

2. How will I determine how well my individual investments are doing?

3. How will I determine how well my overall portfolio is doing?

4. How will I determine if my portfolio is meeting my expected return?

5. 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.

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.