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Invest with Intention by Aligning Your Resources to Your Values

Investing

About the Author
David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management.  While he works with a broad range of clients, David specializes in working with Active and Retired MilitaryFederal Employees, and Families with Special Needs Children.
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Building an investment policy statement: Aligning your resources to your values 

Are you intentional with your saving and investing strategy?  This question is relevant because investing is a critical tool that allows us to achieve our goals and objectives, so we ought to have a plan.   Being intentional in our investing strategy must be informed by two preceding actions.  First, we must be intentional in establishing clear and actionable goals supported by the understanding of why we are saving and grounded in a defined end-state of where we want to be.  

The second step of managing our finances with intention is in developing a clear understanding of our financial picture and building a cash flow to support the attainment of our goals and objectives.  Essentially, being intentional with how we spend every single dollar that comes our way so we have enough resources to invest for future endeavors.

This brings us to the third step of building a life of intention.  The application of our resources in a manner that aligns with our values and enables the attainment of our goals.  This third step is all about how we invest our money to enable the best use of our time and our talents.  Money is simply a tool.  Careful consideration for how we use that tool is critical to ensuring we can get to the end state we so carefully planned for.  So how does one make the best use of their money?  By making it multiply, of course!  Investing is fundamentally about growing an opportunity and should be done with intention.   Intentional investing means crafting a deliberate philosophy and sticking to it.  Good investors will want to develop what is called an Investment Policy Statement (IPS) to help guide their decision making along the way.   The IPS will remind them of their “why” and a good IPS will save lots of heartache along the way.

Intentional Investing Starts with an Investment Policy Statement

Every single investor will benefit from having an investment policy statement.  An IPS is not just reserved for the large institutional investor, managed by committee.  Rather, an individual investor can benefit as much, if not more since we often are relying only on our knowledge and instinct to drive our investment decisions.

An IPS provides the foundation for all future investment decisions. It serves as a playbook for how we will invest, matches our investments to our stated goals, and creates a systematic review process to ensure we are sticking to the rules. The IPS is intended to keep investors focused on their objectives during short-term swings in the market and provides a baseline from which to monitor the investment performance of the overall portfolio.  More importantly, the IPS outlines the mutually agreed-upon set of rules between you and your financial advisor. The IPS is the rule book, the playbook, and the scorebook all in one. A properly constructed IPS enables well-conceived, long-term investment discipline, rather than one that is based on false overconfidence or panic in reaction to short-term market turbulence (Hello COVID!) So, what should go in an IPS?  

Building an IPS

Define Your Investment Objectives

This is usually the first part of an IPS, and the most important. Beyond making money, what exactly are you investing for? What is the purpose of your money? Who and what is this portfolio supposed to provide for? Some of the areas you will want to cover may include:

  • What are your investing goals? (Retirement? College savings? Large Future Purchase?)
  • Which goal should take priority in the event you can’t do it all?
  • When do you want to reach each goal? What’s your time horizon for each goal? And how long do the savings need to last?

Determine How Much Risk You Should Take

In this section, you will want to detail your aggregate risk you are willing to assume.  Risk can be broken down into three categories:

Risk Tolerance (Willingness to take risk): Risk tolerance attempts to define the investor’s attitudes about generalized market risk.  It can be defined as an acceptable percentage of downside in an annual period, or from peak to trough (maximum drawdown).  Put another way, it measures your willingness to take on market volatility and stay invested.  Risk tolerance is typically determined by conducting a questionnaire or survey that attempts to categorize your outlook given various market conditions.  Risk Tolerance alone is not enough to determine how you should be invested.

Risk Capacity (Ability to take risk): Risk Capacity is simply your ability to assume risk given your income, financial resources, and time available.  It identifies the limit of something bad happening in the portfolio without ruining your goals.  If you have an abundance of time or a healthy income you may be able to assume more risk than say someone who has a tight timeline, or whose income varies.

Risk Requirement (Need to take risk) It is the amount of risk that the investor "must" take to reach their financial goals. It defines the rate of return necessary to reach your goals given the time and resources available. The risk requirement can be determined by making some market assumptions for how different asset classes should perform.  Often, a financial planner will use a Monte Carlo simulation to determine the number of outcomes your plan is successful.  A low score could indicate you have a higher risk requirement to increase your chances of success.

All three of these components of risk assessment inform your aggregate risk and your aggregate risk should drive your strategy.

Select Your Strategy

Start by defining your investment philosophy in broad terms such as growth, balanced, or value and state your over-arching investment strategy.  Do you believe in active fund managers, or are you a hardcore index investor?   Perhaps you’re a mix of the two.

Then determine what are your preferred investments that support your strategy? Investors have access to an entire universe of investments, so you should define the types of investments you are both comfortable investing in, and meet your desired level of risk.   Are you interested in stock index funds? What type of Bond funds? Do you prefer Target-date funds? Or are you an investor who likes to pick individual stocks?

If you like certain sub-assets classes (i.e., assets with specific characteristics), include them here and state preferences for particular types of investments, such as small-cap or mid-cap stocks, Real Estate Investment Trusts, or even commodities. Or you can also keep it simple and just leave out sub-asset classes.

An important part of the selection section is to detail permissible (and impermissible) investments. Your goal here will be to detail any investment restrictions such as credit quality and  corporate social responsibility exclusions that may be important to you, such as environmental, social, and governmental screening criteria (e.g no tobacco)

Determine Your Asset Allocation?

Once you have determined what types of investments you want to use you must determine how much of each should be held in your portfolio.  This is called asset allocation and is the underpinning of Modern Portfolio Theory.   Asset allocation is informed by the investor’s profile, their aggregate risk, their investment objective and time horizon, and their strategy.

Setting an asset allocation entails establishing the percentage of your portfolio that you'll invest in broad asset classes and the determination of appropriate benchmarks that will be used to evaluate ongoing performance.  This is done by reviewing the long-term performance and risk characteristics of various investment categories and balancing risk and rewards of market behavior.   These categories will likely include US Large, Medium, and Small Cap Stocks, foreign developed and emerging markets.   For bonds, the decision will be what percentage of US investment-grade bonds, corporate bonds, municipal bonds, foreign bonds, and cash should be held.

As part of your asset allocation strategy, you should also determine how you want to handle “drift”.  That is the propensity to add risk during bull markets (top) and to reduce risk during bear markets (bottom). In times of extremes, your IPS can act as an impartial reference guide, keeping you on the right path to reach your long-term objectives, regardless of market swings.

Set Rebalancing Rules

In this section, you'll provide some general parameters for rebalancing or resetting your portfolio.   Are you comfortable with setting an annual, or quarterly date that you will rebalance?  Or do you prefer to set a tolerance band (e.g. 5% over or under) that will trigger you to buy or sell more of an investment when the allocation drifts outside of your target?  

You should also establish your dividend policy on whether you intend to reinvest them or take them as cash. Sometimes this section will be quite detailed. Other times, it's very general, simply delegating rebalancing responsibilities to the professionals who manage the portfolio.

Review

Lastly, you should hold yourself accountable.  Determine how often you intend to review your IPS.  Life isn’t stationary and neither will be your IPS.  Your goals and situation will change, and that’s ok.  To keep your IPS relevant you should set up business rules to determine how often you will review your statement, but should be reviewed at least annually.

Before every investment decision, you should review your IPS to help you avoid constantly tinkering with your investments. Your IPS is there to help guide your decision making and ensure you remain intentional with your investing.  Before you touch your account, review your IPS and remind yourself of the “why” behind every investment decision.