How To Create An Investment Plan That Will Lead To Financial Success

Jan. 25, 2012 2:05 PM ET
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Contributor Since 2011

How to Set a Financial Plan

You don't have to be a large institutional investor to have a robust investment policy statement (IPS). Here are some basic guidelines to setting up and managing your own IPS.

Although these documents can be long and complicated, there is no reason why they have to be. In fact, the best policy statements are the ones that say everything they need to as succinctly as possible. An investment policy statement consists of three essential parts:

  • return objectives
  • risk tolerance
  • special circumstances.

These are all interrelated, but deserve to be addressed and formulated separately. With Jemstep, you have the tools for setting up an IPS right at your fingertips by simply signing onto the site and providing answers to the questions the site prompts, relating to your specific investment goals.

Once you have determined your own response to these three policy considerations, you can then go about setting out an asset allocation framework consistent with them.

Return Objectives

Perhaps surprisingly, many investors fail to actually translate their return objectives into an actual defined statement. "I want to make tons of money as soon as possible" is not a return objective. "I want to generate returns at least in excess of annual inflation by 1-2%, with an orientation towards growth (capital appreciation) over income" is a reasonable return objective. Investors find that it can be incredibly helpful to simply take a bunch of general ideas and boil them down into a statement. A return objective should be concise, realistic (i.e. not "doubling my money every year"), and descriptive (for example, specifying a preference for asset appreciation over income, or vice versa).

Risk Tolerance

Next, think about how much risk you feel comfortable taking in pursuit of targeted return objectives. Many investment advisors supply their clients with risk tolerance questionnaires to assess what portfolio strategies to put them in. Fortunately, you can do this without hiring an investment advisor, by signing onto Jemstep and filling out the questions pertaining to your attitude towards risk.

Risk tolerance can be broken down into two parts: risk capacity and risk propensity. "Capacity" has to do with your financial circumstances - how much net worth you possess, what your income needs are to preserve your lifestyle, and what percentage of your total income needs are represented by the portfolio. "Propensity" relates to your willingness to potentially take very large losses in the short term in pursuit of higher longer term returns. Think about how you felt during the extreme volatility the market was experiencing every day in late summer and early fall last year. Did you check your 401(k) every day in a panic? For the sake of sleeping well at night during such periods, it pays to be honest about your attitude towards risk.

Special Circumstances

The third section of the policy statement is where you map out all the things that loom large in your financial plans. For example, "time horizon" is a special circumstance - what are the major events that are in your line of sight, looking ahead? This might be college education, starting a business, buying a vacation home or retiring. Related to time horizon is the circumstance of "liquidity needs" - based on these future events, how will your required income stream vary up or down? Finally, issues such as tax and legal considerations can be considered special circumstances - for example, national or municipal residence status, philanthropic designations, and so forth.

Going through this exercise of setting out your investment aspirations in a policy format can provide increased clarity about the right decisions to make for your portfolio. Armed with a grounded set of statements about your return objectives, risk tolerance and special circumstances, you can compare the risk / return properties of different investments (equities, fixed income, and so forth) and allocate weights to different instruments, in line with the policy. It is a good discipline, one that can lead to increased success in investing over the long term - and the foundation of Jemstep's personalizedinvestment recommendations.

Tell Us…Do you have an investment policy statement?

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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