Do You Have An IPS?

I am writing this article in early March 2021. The markets have been up and down lately as we continue through the COVID-19 Pandemic. Bond yields, vaccine approvals, interest rates, stimulus packages, corporate earnings… News in any of these areas and a thousand others cause the market to fluctuate daily. Volatility is to be expected when investing in the stock market because it comes with the territory. However, it seems the volatility continues to be magnified due to the current state of affairs in the world. For this reason, I think it is a good time to talk about the importance of an IPS and why you should have one if you don’t.

What is an IPS?

An investment policy statement (IPS) is a document that outlines your investment goals and objectives to include the specific strategies you wish to employ to achieve said goals and objectives. An IPS can be utilized as a formal roadmap for your investment manager if you have one, or it can simply be utilized as a personal roadmap as you manage your investments and seek to achieve your financial objectives. Since I choose to manage my own investments, I fall into the latter camp. 

What is in an IPS?

There is not necessarily a universal template for an IPS. However, there are several core elements to an effective IPS including the following:

• Long-term financial goals and objectives
• Investment timeline
• Target asset allocation to include asset classes (stocks vs. bonds) and sub-asset classes (domestic, International, large-cap, small-cap, etc.)
• Rebalancing procedures
• Monitoring and reporting procedures
• Update/control procedures

Although these are several core elements of an IPS, it can ultimately be as simple or as complicated as you want it to be. I personally prefer simple because complexity in my life often leads to inaction or failure to follow through completely. I am a subscriber to the KISS (Keep It Simple Stupid) method.

Who Needs an IPS?

Do you have long-term financial goals? If your answer is yes, then you need an IPS. If your answer is no, then you first need long-term financial goals and then you need an IPS. IPS = YES.

What is the Benefit of an IPS?

An IPS serves multiple purposes. As noted above, it is a roadmap for your financial life. Developing an IPS forces you to sit down and define your goals and objectives and determine your strategy for achieving them. The process in itself adds value as you must define your destination and then define your path for getting there. Once you spend the time to develop an IPS, it will ultimately serve to improve your decision making since you have a framework to follow.  This is critical to avoiding financial mistakes that may prevent or delay you from achieving your long-term financial goals and objectives. As Benjamin Franklin famously said, “If you fail to plan, you are planning to fail.”

When to Create an IPS

As I said above, if you have long-term financial goals, I recommend you create an IPS. If you are reading this blog, you undoubtedly have financial goals so if you don’t have an IPS, the time is now. It is also an excellent time to create an IPS because markets have returned to all time highs and there will undoubtedly be a correction some time in the future. Corrections and bear markets are inevitable. The key to successful long-term investing and building wealth is not acting on emotion and not making decisions detrimental to your long-term goals. Trying to plan when the proverbial sky is falling is not a good idea. This is why having an IPS during a bear market is such a valuable tool. You can return to it to remind you of your long-term goals and strategy to avoid making decisions that may delay your financial independence or worse. 

How to Create an IPS

Traditionally, documents of this nature are utilized by investment advisors to help guide their decision making when working with clients. However, they are not difficult to create, especially if you focus on the core elements and create guiding principles that are simple yet specific enough to guide your investment decisions. With a quick search of the web, you will find many templates and examples that you can utilize to form the basis of your IPS. When I first started my journey to financial independence, I had an informal IPS written down even though I didn’t necessarily know what an IPS was at the time. It wasn’t until a few years ago that I sat down and actually created a formal IPS for Mrs. Henry and I. Since its inception, we have been using it to guide our financial decision making and goals. Today, I figured I would share my IPS to allow you to see not only our investment objectives and guiding principles, but also the core components that we have included and why.

Henry’s Investment Policy Statement

The first section of our IPS outlines our financial goals and objectives taking into consideration our current financial resources, goals, timeline, risk tolerance, etc. I have mentioned most of these goals in previous posts. Obviously we’re are on our journey to financial independence, and I previously stated our FI number was ~ $2.8MM. These are a given. However, there are several other goals outlined here that I have spoken less about up to this point. There will likely be future posts about many of these areas as we continue to document our journey to financial independence and beyond.

Goals/Objectives:

1. Achieve financial independence, work optional by our target date. (Note: Our actual IPS includes our target date and milestones along the way. I removed these for the purpose of this post.)

2. Carry no debt other than mortgage on primary home and investment properties. Pay off mortgage on main home on same timeline of achieving financial independence.

3. Cover 50% – 90% of college tuition costs for children through cashflow or investments/savings. Also leave a meaningful inheritance to children and teach them value of saving, investing, and frugality and that money is simply a tool in life.

4. Generate an annual income of $100,000 in today’s dollars (long-term inflation rate assumed at 2.5% – 3%) providing us financial independence based upon a 3.25% – 3.5% safe withdrawal rate. Resulting financial independence number = ~ $2.8MM – $3.0MM. The intent of this income is to allow us to have the desired standard of living upon leaving W2 employment (allowing for increased travel) to include medical costs, long-term care, and to fund estate-planning tools when social security becomes available to us at age 62-70.

5. Minimize tax liability before and after achieving financial independence through tax diversification and leveraging tax-advantage investment vehicles. This includes contributing the maximum to tax advantaged vehicles available each year.

The second section of our IPS outlines our specific savings goals and objectives. When seeking to achieve financial independence on a non-traditional timeline, your savings rate is key. For this reason, we created a separate section and will make modifications as needed as we progress along our journey. If you recall from my recent post, we achieved a 46% savings rate during the previous year. We continue to seek to maintain or achieve these goals each year on our journey to FI.

Savings Goals/Objectives:

1. Save 40% – 60% of annual income (gross savings/gross income) every year. (Note: Some people utilize after tax income to calculate savings rate. Others utilize gross income after taxes. I suppose there is no right or wrong way to calculate savings rate. I have always calculated it this way and it makes sense to me. For this reason, I recommend calculating your savings rate utilizing your gross income.)

2. Contribute the maximum to available tax advantaged vehicles available each year. This includes a ROTH IRA contribution (back-door as necessary) each year x 2.

3. Maintain between 6 – 12 months in living expenses in a high-yield savings account or other FDIC insured vehicle.

4. Save at least 10% of annual gross income in taxable investments. 

The third section of our IPS outlines our investment approach. As I have noted in previous posts, we seek to invest primarily in index funds, minimize taxes, avoid mistakes, and track our progress on a regular basis.

Investments:

1. Strive to minimize the effects of taxes and expenses on our investment returns both prior to achieving FI and after achieving FI.

2. Primary investment vehicles will be stock index funds and bond index funds, preferably within tax-sheltered accounts. 

3. Consideration will be given to real estate investments to meet our goals if careful analysis indicates the opportunity will provide value-added diversification and an opportunity to profit. We will NOT consider this investment vehicle unless we are saving 40%+ of income annually.

4. Savings rate, portfolio returns, and net worth will be tracked and reported at least quarterly.

5. Strive to achieve an annual real return of at least 5% annually.

6. Investments will not be sold during market corrections. Stay the course and remember the market goes up over time and a 30% – 40% loss is normal based upon asset allocation.

The fourth section of our IPS outlines our approach to home ownership. Pretty straight forward with not much else to add. This section is obviously highly personal and will vary based upon where you live and your approach to renting vs. owning.

Home Ownership:

1. Strive to own a home rather than rent. Pay off mortgage on main home on same timeline as achieving financial independence.

2. Put down 20% on any new home purchase to avoid PMI. Do not spend more than 20% of income on housing costs to include mortgage, property taxes, and utilities. A new home may be purchased even if it extends FI timeline, but only after much deliberation and ensuring the new home will improve happiness and align with values.

3. Will not utilize home equity loans to expand lifestyle. Home equity loans are only to be utilized in a low interest rate environment to make a real estate investment if criteria above is met.

This fifth section of our IPS outlines our general approach to spending money to include our stance on credit. As I have noted in previous posts, we utilize credit cards for the majority of our spending. However, we do not carry credit card debt to avoid interest and lifestyle creep funded through debt.

Spending:

1. Spending will be tracked to ensure appropriate use of financial resources. All spending will be tracked for minimum of three years. Spending can be tracked more loosely after three years if desired, but it must again be tracked three years prior to achieving FI and beginning to draw down on investments.

2. Debt will not be utilized to finance such things as automobiles, boats, appliances, furniture, or vacations. Credit will only be utilized for convenience, mortgages, and safe, fixed-income investments to include real-estate. All revolving credit must be paid off within defined timeframes to avoid interest OR only if the interest is less than the income of the financed amount.

The sixth section of our IPS outlines our emergency fund guidelines. It is important to note here that many people include their emergency fund in their fixed income allocation. However, we do not. We also are OK with reducing our emergency fund based upon the size of our taxable investment account.

Emergency Fund:

1. Maintain an emergency fund equal to at least 6 – 12 months of living expenses in liquid FDIC insured savings vehicles. The emergency fund can be reduced to 1 – 3 months once taxable investments can serve as an emergency fund assuming a 70% loss in principle. 

2. The emergency fund will not be counted as a part of fixed income allocation.

The seventh section of our IPS outlines our desired asset allocation and rebalancing criteria. I would say we have a pretty straight forward and simple approach in this area. We also strive to have parameters in place that prevent us from making short-term decisions involving alternative or new investments that may impact our long-term objectives. These parameters are designed to keep us from jumping on a bubble for fear of missing out (FOMO). As of the publication of this post, examples would be the recent run-up in Tesla, Bitcoin, etc. 

One interesting note that I will get into in a future post is our chosen asset allocation. We are currently at 80/20 with 20% of our equity investments being in international funds. This works out to ~ 16% of our overall allocation. Many would argue that your international allocation should be closer to 40% of your equity allocation, and you will see many target date funds allocated in this manner. I personally believe anything from 20% – 40% is reasonable, and we happen to land on the lower end of the spectrum.

Asset Allocation:

1. Overall asset allocation will be 80% equity investments and 20% fixed income investments. Equity investments will be 80% domestic and 20% international investments (this works out to 16% international overall). Investment real estate and home will not be calculated into this figure. Emergency fund will not be calculated as part of fixed income. (80/20 or 64/16/20 or 51/13/16/20).

2. Asset allocation will decrease gradually to at least 60% equity investments and 40% fixed income investments prior to leaving W2 employment. Approach will be determined close to FI date but will likely be a “glide-path” type approach.

3. Primary asset classes will be domestic stock index funds, international (emerging and developed) stock index funds, and bond index funds. No individual stocks are to be purchased. However, at least 20% of equity will remain in international investments and alternative investments must meet other criteria within IPS. (Note: I am a subscriber to a Three-Fund Portfolio for the most part. You can read more about this approach on the Wiki of the Bogleheads Forum here.)

4. Alternative investments will include REITs, businesses, and real-estate only.

5. Rebalancing of asset allocation will be done annually in February OR utilizing the 5/25 (5% absolute or 25% of allocation for smaller allocations) rule using new investment money as much as possible. If selling in a taxable account (or selling an investment with significant trading costs) is required to rebalance, this may be performed no more than once per year.

This eighth and final section of our IPS simply outlines our criteria for making changes. It is our control mechanism. Simple yet effective.

Changes to IPS:

1. Any change to asset allocation percentages or primary asset classes will require a 3 month waiting period. 

2. Development of any new asset class or new funds allowing us to invest in a new asset class will require a 6 month waiting period to avoid FOMO and bubbles. This will likely be tested. Reference Dutch Tulip Bulb Bubble when considering changes to alternative investment asset classes. Avoid FOMO actions.

3. Any other changes to IPS will require a 3 month waiting period.

Although I don’t consider it a part of our IPS, I also include several quotes that I think are applicable to staying the course and successful long-term investing. I have included a few below.

Quotes:

“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” — Warren Buffett

“Don’t look for the needle in the haystack. Just buy the haystack!” — John Bogle

“The individual investor should act consistently as an investor and not as a speculator.” — Ben Graham

“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” — Robert Kiyosaki

“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble” — Warren Buffett

“The ability to do what you want, when you want, with who you want, for as long as you want, is priceless. It is the highest dividend money pays.” — Morgan Housel

The Importance of an IPS

“A goal without a plan is just a wish.” — Antoine de Saint-Exupéry

I will end this post where I began. An IPS is a valuable tool in your financial tool belt because it forces you to make a plan with the goal of sticking to it through good times and bad. It is important to note that an IPS is not meant to be a static document. Revisions can and should be made based upon life changes and your evolving financial situation. What is important is ensuring changes are made utilizing sound decision making and that they align with your guiding principles and long-term financial goals and objectives. You can achieve financial independence without an IPS, but it certainly can’t hurt to have a plan. I hope my post today will inspire you to create your own if you don’t already have one. If you already have an IPS, hopefully seeing mine provided some value simply by having another reference point in addition to your own. So, how about it? Do you have an IPS?

Regards,

Henry