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Your IPS: saving you from yourself (part 1 of 2)

Any time you wonder, "that idea seems cool -- should I be investing in that?", or "the market's going up/down/sideways -- should I change how I invest?", the answer should lie close at hand -- in your Investment Policy Statement. An IPS is a great way to save you from shooting yourself in the foot (or, at least, making sure that you do so in a very planned, methodical way, thus minimizing the damage). Building one can take some time and effort, but the good news is that (a) it's designed to change over time, so it doesn't have to be perfect out of the gate!, and (b) once it's in place, you'll find that you spend dramatically less energy on the investing front.

Sound good? Then let's get this done.

Set aside time in your calendar -- as much as you think you can stand in one sitting (pun intended). The time it takes to complete an IPS varies a lot from person to person, so just block out one session, and if you're not finished when time's up, take the last 5 minutes to schedule another go-round. Nothing like a spot in your calendar to ensure something gets done!

In these sessions, you'll be asking yourself some questions. Take your time in answering them, but always remember that your IPS will change over time. The perfect is the enemy of the good, and that goes tenfold for investing.

First: what are your goals? What you invest in depends on entirely on your goals. Take a look at each of your accounts and say, "Is this for emergency savings? A down payment on a car, or house? My childrens' education? Retirement?"

The answer should never be, "I just want my money to grow". You absolutely must have a goal in mind, or you won't be able to appropriately balance risk and reward. If you have no idea, then pick one that seems most likely -- as I said, your IPS will change over time, and that includes the goals for each account. If you want ideas, try asking like-minded friends who are 10, 20, and 30 years older than you are what they wish they had saved for. It's the closest you can get to asking Future-You for advice!

You may find that some of your accounts are split between multiple goals, or several accounts are working towards the same goal. That may be fine, or that may be something you want to change; for now, just make note of it and move on.

What's your risk tolerance? I (and other financial advisors) mean something very specific when I say "risk tolerance", and it's not the same as "risk capacity". "Risk capacity" is the amount of risk that makes analytical sense for a given goal -- for example, if you need the money next week, then a numerical analysis using expected returns and standard deviation will show that putting the money in the stock market will likely not maximize your chance of success. However, if you won't need the money for thirty years, the analysis shows that investing your money entirely in stocks ("equities", as the analysts like to say) will maximize your chance of higher returns.

That's all well and good, but it's a different story when the market is crashing and it's your money that's seemingly vaporizing before your eyes. How much of a drop could you stomach before you bailed out and threw everything into cash? That, in a nutshell, is your risk tolerance.

How much of a drop might your portfolio take? Well, let's say you had all of your investments in a 60/40 combination of Vanguard's Developed Markets fund and their Total (US) Stock Market fund. Through the Great Recession, it would have seen a peak-to-trough plummet of 57.2% from 10/31/07 to 3/9/9 (495 days), and it would have taken 1,422 days -- 3.9 years -- to recover. However, $10,000 invested in that portfolio 20 years ago would have grown to $36,699 today. (Okay, true, the Developed Markets fund wasn't created until 1999. We're subbing in the MSCI Europe/Asia/Far East index for that first year.)

Compare that to a portfolio invested entirely in Vanguard's Short-Term (US) Bond fund. Its largest drop during the recession would have been a meager 2.4% from 9/15/08 to 10/13/08 (28 days), and the recovery would have taken 46 days. However, $10,000 invested in that portfolio would have grown to $20,257 -- 44.8% less than the stock portfolio from earlier.

The point here is this: you have to make a choice. How much short-term volatility are you willing to trade for long-term returns, and vice-versa? It's an important question -- and it relies as much on your understanding of your own emotions and behavior as anything else.

What's your asset allocation? You've got your goals (and hence your risk capacity), and your risk tolerance. Now you can ask yourself: what should your asset allocation be? In other words: for each goal, what's the right mix of stocks, bonds, real estate, cash, and/or whatever else you might want to invest in? What fits both that goal and your personal risk tolerance?

If you don't know a lot about investing (and, honestly, even if you do), this could be a tough question to answer. Consider William Bernstein's The Intelligent Asset Allocator, if you'd like to do a deep dive and really understand the research behind asset allocation. Or you might consider looking at the asset allocations of some of the mixed stock/bond funds out there, like Vanguard's "LifeStrategy" funds or Fidelity's "Target Risk" funds, just to name two. (I don't have any relationships with either company; they're just two that come to mind.) Check out the historical tradeoffs they've had between risk and returns, look at their underlying allocations, and use that to craft your own. It's not perfect, but it's a good start.

There's a lot of data out there, and a lot of theories on what makes an ideal allocation. Resist the urge to go down a rabbit hole: do some research, make a decision, and move on. Don't let the perfect be the enemy of the good -- you'll be revisiting this later. Remember those portfolios from earlier? Both of them did better than leaving your money in cash!

A final note: for you speculators out there who just have to scratch the gambling itch, feel free to set aside a (small!) percentage of your portfolio for companies, technologies (Bitcoin anyone?), etc. that you just "know" will take off. Your IPS can be as rigorous or as flexible as you want! See the aforementioned Bitcoin post for an idea on how to speculate methodically.

How are you going to implement your asset allocation? Are you going to invest in individual stocks, bonds, or houses? Or are you going to purchase ETF's, mutual funds, or Real Estate Investment Trusts? And how are you going to choose them? Like asset allocation, this is a science and art that requires a deep dive in order to fully get a sense of the alternatives. Having said that, there are a few of thoughts to bear in mind.

One: Purchasing mutual funds versus individual stocks, bonds, or houses is generally a question of diversification versus cost and liquidity. Mutual funds and ETF's have expense ratio costs associated with them that can range from 0.04% to 1.5% or higher, but they provide you with broad diversification; buying and selling individual stocks can be both time-intensive and expensive, since you often have to pay for each trade. Moreover, mutual funds are quite liquid -- you can easily sell them for the going price -- while individual bonds can often be difficult to sell, and real estate ten times more so, unless you're willing to take a severe haircut on price.

Two: if you're looking at mutual funds, the research has shown time and again that low cost is the best predictor of performance within a given asset class. Perfect? No. Most consistent? Yes. There's nuance, but this bit of knowledge will serve you well.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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