A good investment strategy begins with a good policy. While many individual investors think that they or their advisors should try to time the market or pick hot mutual funds and stocks, most professionals understand that your returns are probably dictated more by your investment strategy (statistically, market timers and stock pickers usually underperform most comparable market indices). A sound policy outlining the principal components of your strategy should contain:
1) An outline of the investor’s main objectives such as:
Retirement, college savings, home purchase etc.
2) Strictly quantifiable objectives-for example:
Mr. and Ms. Jones have stated that their goal is to accumulate $1,000,000 within 15 years in order to secure a comfortable retirement income of $40,000 annually which will be subsidized by social security and pension payments. This assumes an annual withdrawal rate of 4%. Any balance and assets remaining after the death of the surviving spouse is intended to be left as per their will dated January 15, 2006. In order to accomplish this goal, the owners have already contributed approximately $300,000 as follows:
Joint account $75,000 Other savings $25,000
G. Jones – IRA/401(k) $100,000
J. Jones – IRA $100,000
TOTAL $300,000
3) Quantifiable intermediate steps - for example
In order to achieve their goal, the clients understand that they will have to save an additional $10,000 per year and earn a return of 7% on their investments, after expenses and taxes.
Your professional should be willing and able to provide specific intermediate goals that quantify intermediate steps. For example, the advisor should be able to tell the client that in the example above, they should have a minimum of $487,986 set aside by the end of year 7. If the client is short of this goal, they may need to set aside additional savings and or increase their allocation to potentially higher yielding, more aggressive investments.
4) A well defined strategic asset allocation strategy (including ranges for each category) – for example:
Therefore, a moderate allocation is recommended consisting of:
Minimum x%/Maximum y% large cap US equities
Minimum x%/Maximum y% mid-cap US equities
Minimum x%/Maximum y% small-cap equities
Minimum x%/Maximum y% large-cap international equities
Minimum x%/Maximum y% small/mid cap /international equities
Minimum x%/Maximum y% diversified bond portfolio
Minimum x%/Maximum y% alternative investments like real estate
5) Tactical asset allocation that outlines exceptions and other general portfolio
restrictions - for example
Fixed income and cash will only be used as needed on a tactical, defensive basis after achieving annual goals and/or during times of heightened market tension and risk as mutually determined by the client and the advisor.
6) Investment parameters – that outlines types of permissible investments,
reinvestment rules for capital gains and dividends etc. - for example
Based on a fundamental appreciation for the tax and investment efficiencies of indexing, exchange traded funds will be used whenever possible. When an appropriate exchange traded fund is not available, mutual funds and/or closed-end funds will be used.
Individual equities currently in the portfolio will not be replaced as they are tactically liquidated. Proceeds will instead be reinvested in the investment vehicles and proportions outlined above.
7) Rebalancing frequency – generally once or twice per year although individuals with larger levels of assets (generally $2,000,000 and above) may wish to rebalance more frequently as a risk management tool.
8) Statistical parameters developed by your professional which will include a general measure of risk (usually standard deviation) and any benchmarks they are attempting to measure performance against - for example (this includes technical financial terms and your advisor can explain to you what each means):
The portfolio will seek to contribute positive alpha relative to this index with a standard deviation no more than 10% greater than that of the S&P 500 index at the time of rebalancing as measured and subject to the limitations of the analysis offered by XYZ software (will vary by advisor).
9) Signatures – the document should be signed and agreed to by both the client and the advisor demonstrating that both the client and the advisor
understand the client’s objectives.
