How many people do you think have a written investment plan like this?
“I invest to make as much money as possible. I want the highest return even if I have no clue how much I actually need for the lifestyle I want, and have only a vague notion of how much I’ve made (or is it how much I’ve lost?) in the past.
“I will invest in anything as long as somebody is recommending it, even if I have no idea what it is, how much risk I am taking or how it all fits together in my portfolio.
“I will take my tips mostly from seminars where somebody is trying to sell me something and from television and the “10 Funds You Absolutely Must Own Now” lists in the magazines. I will jump from investment to investment as those lists change.
“If the stock market tanks, I’ll take my losses and run. At first I’ll swear to stay out of the market forever. But I’ll get greedy when the market comes back up and buy back at higher prices.”
Nobody would write such a plan, of course, even if that’s the way too many people “invest.” The problem is, very few people have a written investment plan, period. If they did, they would be far less likely to make all those mistakes.
In the jargon of financial planning, such an investment plan is called an “investment policy statement.” This statement clearly articulates the investor’s objectives and how investments will be chosen and monitored to meet those goals.
“With an investment policy statement you avoid panic selling and excessive optimism or risk taking,” said Jay Shein, a certified financial planner and CEO of Compass Financial Group in Lighthouse Point, Fla.
Investment policy statements prepared by financial planners can be quite detailed. From a legal standpoint, such statements also serve to adhere to prudence and diversification standards.
But the basic concepts–spelling out goals and expected returns, time horizon, risk tolerance and investment strategy–need to be part of every investor’s plan.
If you hire an adviser, you should insist on receiving and agreeing to such a policy statement. If you invest on your own, you must at a minimum include the basic concepts in your own written plan.
“Some of these things are `feeling’ things,” Shein said of what should be included in the statement, such as in the area of risk tolerance, which is very difficult to quantify.
In general, an investment policy statement should include at least the following:
– A well-defined and specific investment objective, such as the amount of money the investor wants to have by a certain time, or the amount of monthly income the investor wants to receive from a portfolio.
– An expected rate of return over time, consistent with historical investment performance and often expressed in terms of “real” return above inflation.
– Time horizon, including how soon the investor expects to start withdrawing at least some money from the portfolio.
– Risk tolerance, which should include the biggest loss the investor is willing to accept over a specific time period, such as one to three years.
– Asset allocation, or how the portfolio is to be split among different asset classes to try to achieve the expected rate of return without exceeding the investor’s risk tolerance.
– Criteria for selecting or rejecting investments. (For example, you may decide that sector funds are too risky and limit them or not invest in them at all.)
– Portfolio liquidity, or how much of it you can sell quickly without the risk of a major loss in value.
– Frequency of review, or how often the overall plan will be reviewed and adjusted if necessary.
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Humberto Cruz can be reached at AskHumberto@aol.com or c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1500, Chicago Ill. 60611.
