Why you need an Investment Policy Statement

People have been creating investment plans for a long time.

It looks like the first on record dates back roughly 4,000 years ago, and was created by an ancient Sumerian wanting to figure out how much milk and cheese his cows would produce over the next ten years. It forecasts the growth of a herd of cattle, with the number of cows increasing exponentially – in what is likely the earliest example of recorded compound interest.

Interestingly, the idea of repaying debt using herds of cattle could well be where the idea of charging interest came from. If you lend your Sumerian neighbour your cattle, you’d expect some interest in return – in this case, calves. And the Sumerian word for interest is mash, which also means “calves”.

Like many modern investment plans, however, this particular model depended on a few questionable assumptions – no cow ever dies, and each pair always has one calf. So it’s about as realistic as Cathie Wood’s forecast of her fund’s 50% annualised returns.

Despite the practice being 4,000 years old, creating an investment plan is still a crucial exercise for modern-day investors. And yet, although they’re common in the institutional world, almost no DIY investors make them for themselves. And I think this is a mistake.


What is an IPS?


An investment plan, more often referred to as an ‘Investment Policy Statement’ (IPS), is created when an investor appoints somebody to manage a portfolio on their behalf. It’s the keystone document, outlining the relationship between the investor and the investment manager. It documents the investor’s needs for the portfolio, and how the manager will run the portfolio to meet those needs.  

In terms of content, it includes the purpose of the investment, the governance surrounding the portfolio (who can manage the portfolio or make changes to the IPS), the return/risk objectives, and how the portfolio’s risk will be managed. It’ll also include details on asset allocation, investment restrictions, income requirements, tax circumstances, time horizon, reporting/monitoring requirements, benchmark details, and any legal/regulatory requirements.

They can be pretty lengthy.

Having a document which codifies both sides’ responsibilities is clearly important – it ensures the investment manager doesn’t go off-piste, and that the client is happy with the investment philosophy and overall approach for the management of their portfolio.

So it obviously serves a purpose when outsourcing your investments to a third party.

But there’s no need to get two separate parties on the same page if you’re managing your own investments. It’s just you.

So why is it also useful for us DIY investors?


Why do you need an IPS?


“Most battles are won or lost long before the first shot is fired.”

This Napoleon quote is supremely relevant for investing.

In my day-job, I see all sorts of clients. Some have been investing for decades, some have only just started. Some are investing experts, some are novices.

The clients who end up being the successful investors – those who are able to stick with their investments through the inevitable bear markets and underperformance – are the ones who spend the time acquainting themselves with the potential for losses, the investment philosophy, and realistic expectations for their portfolio. But the key point is they do all this before they invest.

The clients who don’t end up being quite so successful – those who decide to switch into a lower risk portfolio during a crash, or those who aren’t able to stay invested at all – mostly end up that way due to insufficient work being conducted prior to investing. Either the client didn’t accurately disclose their circumstances and requirements, or, more often the case, we as the investment managers failed to adequately enumerate the investment philosophy, risks, and expectations for their portfolio.  

In both cases, success and failure were already determined. They’d sealed their fate, for better or worse, before the first pound was invested.

Getting things right before investing is crucial.

And this applies just as much to DIY investors as it does to those who choose to outsource.

For DIY investors, the main benefits of creating an IPS are twofold. Firstly, it makes your portfolio easier to stick with, and secondly, it stops you from making mistakes.


1. It makes your portfolio easier to stick with

Next week’s post will be all about how to create an IPS.

But for now, one of the first things to include in your IPS is the reason you’re investing. It’s surprising how few people give this much thought.

For me, it’s becoming financially independent. For you, it might be saving for a house deposit. Or leaving a legacy. Or saving for your children to go to university.

By clarifying the reason for investing, you’re giving yourself a “why”. And as Viktor Frankel says in his superb book, ‘Man’s search for meaning’:

“A man with a why can withstand almost any how.”

If you know why you’re investing, you’re far more likely to invest successfully.

Another key component of an IPS is documenting the investment philosophy. Are you adopting a purely passive approach? Purely active? Some blend? If so, what’s your approach to active investing? Is it factor investing? If so, which factors? What would cause you to change your approach?

By writing down your investment philosophy – even in just a few lines (it doesn’t have to be more than that), it a) encourages you to make sure the approach you want to take is right for you, b) once you’ve decided, writing it down in your IPS encourages you to commit to it, and c) it sets down a set of conditions under which you’d modify your approach.  

The combination of these two “whys” – why you’re investing, and why you’re investing in this particular way – is enormously helpful in ensuring you’re able to stick with your portfolio.


2. It stops you from making mistakes

The primary purpose of an IPS is to stop you from making a mistake.

I wrote recently about how there are an almost unlimited number of ways to invest successfully, but only very few ways to fail at investing.

And if you look at that list of ways to fail at investing, a large number of those mistakes can be mitigated by creating an IPS, and then sticking to it.

For example, my own personal IPS stops me from:

  • Taking concentrated positions
  • Having a single point of failure
  • Paying high fees
  • Using leverage
  • Chasing performance
  • Searching for the perfect portfolio
  • Taking too much/too little risk
  • Gambling

That’s a good chunk of mistakes I’m not going to make if I stick to my IPS. And given investing successfully is just a relentless effort to avoid making mistakes, an IPS is a valuable thing to have. 

So how does it miraculously prevent all these mistakes?

By reducing decision-making.

Each time we make a decision, we risk making a mistake. The fewer decisions we make, the fewer mistakes we make. By creating a documented, rules-based approach, it reduces the number of decisions, and therefore the number of mistakes.

I’m going to be less tempted to stick a massive allocation into Tesla if I’ve got it written down in my IPS that no single stock should be more than 1% of my portfolio. I’m going to be less tempted to chuck a big slug into the latest tech fund if my IPS states my target allocation is 20% equities. Because I’ve thought about these things up-front, before I invest, it means I already have a plan for when I’m faced with a decision.

Alongside the benefits of documenting the reasons for investing, the reasons for adopting your investment philosophy, and the rules surrounding your portfolio construction, a further benefit I’ve found to having my investing strategy physically written down is that it provides me with rules to follow when I’m not sure what to do.

For example, if you like to dabble in stock-picking (guilty), having an IPS is useful for documenting your strategy. Because, as we all know, things don’t always go to plan.

You’ll need a gameplan for when your stock falls 30%. Do you sell? Trim? Or buy more?

You’ll also need a gameplan for when your stock underperforms the market by 30%. This can be equally as painful. 

On the upside, you’ll need a plan if your stock rises 30% and becomes a larger part of your portfolio.

Under what conditions do you sell your stocks? Do you sell them outright, or trim them? What do you replace them with? How often do you monitor them?

All these things can be written down in your IPS. Because when the time comes and your favourite stock falls 50%, then you’re going to need a plan. Otherwise you’ll be making decisions based off all sorts of things. The news. Your emotions. What your friend’s telling you.

And that’s a guaranteed way to make a mistake.

I’m not saying an IPS can solve all your investing problems. At the end of the day, an IPS is just a few lines written down somewhere which lays out how you approach investing. Mine is just a handful of lines in Excel.

It doesn’t need to be perfect. It can’t possibly cover every conceivable scenario, nor can it physically restrain you from making a bad decision. But what it can do is lay down some ground rules, giving you a roadmap for why you’re investing, your broad philosophy, and some rules on how you intend to manage your investments.

Don’t let the perfect be the enemy of the good.

I’ve found this works extremely well for my own investments. I revisit my IPS once a month (even calling it an IPS is a stretch – it’s just a few lines in my finances tracker) when I record my investment performance, or when I’m considering making changes to my portfolio.

I also have a similar approach to my broader personal finances. I guess you could call it a ‘Personal Finance Statement’, which covers things like rules for how much I invest each month, what I do with pension contributions, how to deal with pay rises/bonuses, how to optimise for minimising taxes, and all that good personal finance stuff. Both my IPS and my personal finance statement are less than a dozen lines each, and could probably each fit on an index card.

For next week’s post, I’ll be providing some guidance on how to create your own investment policy statement, as well as sharing my own.

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Past performance does not guarantee future performance and the value of investments can fall as well as rise. The information on this site is provided for information only and does not constitute, and should not be construed as, investment advice or a recommendation to buy, sell, or otherwise transact in any investment including any products or services or an invitation, offer or solicitation to engage in any investment activity. Please refer to the full disclaimer on the disclaimer page.

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May 17, 2022 11:11 am

Really good article Occam and I couldn’t agree more. I didn’t realise it but I have my own IPS in terms of how much I invest each month and to what broker/investment pot so that it has now all become automated via direct debits that go out on a set date to my ISA, LISA etc. And I agree that taking a long time before you start investing to plan everything out helped me tremendously – personally I read about 30 books on finance and investing to feel confident about what I wanted to do and how I was going to do it before I started putting serious money behind my ideas. Secondly, I think knowing your time horizon and investment objective is one of the most important decisions you can make – I’m 31 and investing for FIRE and so I have a 15-30 year time horizon (with indiviudal goals amongst that) that makes me quite relaxed in periods like March 2020 when the market bottoms out, or at the start of this year when we had a correction. Equally, I’m quite bullish on Crypto because I’m looking at it with a 10-20 year view. I was arguing with my brother yesterday about it as he’s of the view that crypto is risky seeing as bitcoin lost half its valuation recently. Which is objectively true. But then my timeline is much broader so I see it as bitcoin increasing by 4,000% between 2016-2021, or I believe by +45,000% since inception. The relative perspective changes everything and so while a lot of people are freaking out about the markets now (both stock and crypto), i’m largely indifferent because of the IPS i’ve done. Really long way of saying I agree with you, but I thought context would be helpful as to why.

May 18, 2022 5:21 am
Reply to  Occam

Fair enough about crypto. I personally only invest in Bitcoin & Ethereum as those are the only ones where I understand the user case and think they have a long term future. And I would still understand if people don’t want to go too bullish on it, it’s a new concept. It’s just my personal viewpoint for that and of course, I could ultimately still end up being wrong. And thanks regarding the latter! I am doing my best. The more I read and study, the more I find out that the majority don’t! Blogs like yours and The Financial Samurai, The Escape Artist, Monevator, The Humble Penny, A wealth of common sense, I find are a goldmine. So thanks for all the great content.