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Investing 101

Everything you need to know before you build a portfolio

How to Create Your Personalized Investment Roadmap

July 1, 2019

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

If you’re like many people, you probably enjoy traveling. The first thing you may do when you decide to go on a trip is figuring out the destination. Once you’ve picked a destination, the next step is to figure out the directions on how to get there. In the context of financial planning, the destination is your goals and your Investment Policy Statement (IPS) is the roadmap to get you there. Having an IPS may sound like something for advanced investors, but it’s actually something everyone should create when they think about getting started with investing.

To move beyond wishful thinking to producing tangible results requires knowing your specific goals and a well-crafted action plan. An IPS outlines the parameters of your investment plan: the asset allocation framework, criteria for selecting investments, and the procedures for maintaining those investments on an ongoing basis.

The purpose of this article is to provide a high-level outline of the steps needed to create and maintain your plan. You can follow these steps yourself or work on them in conjunction with your financial advisor.

1) Determine Your Objectives

a. Return Requirements- The first thing you need to do is to determine your long-term goals both on a mandatory and aspirational basis. Examples include, “I want to retire at 60” or “I want to retire at 60, travel, and buy a vacation home.” The fact that you want to retire at 60 is a mandatory goal. The goal of traveling and buying a second home is an aspirational goal. Next, you need to figure out what type of return you will need to get to these goals. Your required return is the return you will need to meet your mandatory goals. Your desired return is the return necessary to meet your additional aspirational goals.

a. Risk Tolerance- The best plan is the one that you can stick to. Risk tolerance is separated into your ability to take risk and your willingness to take risk. Your ability to take risk depends on your personal circumstances and financial situation. Your willingness to take risk is psychological and is based upon your unique relationship with risk and reward. For example, if you are anxious about the volatility of the stock market, having all of your assets in equities would not be advisable. However, if you are more willing and able to take risk, then a portfolio of all bonds would not be suitable for your situation.

2) Determine Your Constraints

Time Horizon- This is the amount of time over which your portfolio must grow to be able to meet your objectives. Often times this can be a multi-stage timeline. For example, a 30-year-old may have the objectives of 1) buying a house in 5 years 2) paying for a child’s education in 18 years and 3) retirement income starting in 30 years and lasting the rest of their life.

a. Liquidity- This is the ability to access your money when you need it. Some consideration examples include: will I need income from my portfolio to live off of, do I have a need for a lump sum payment in the near future (such as a down payment on a home or funding a business venture) and do I have an emergency fund?

b. Taxes- Investors should be most concerned about their after-tax rate of return. Your objective is to keep as much of your money and gains as you legally can. Methods to do this include using tax-advantaged retirement accounts, municipal bonds, 1031 exchanges, etc..

c. Legal and Regulatory- This constraint mainly applies to institutional investors such as foundations and trusts that have to follow the prudent investor rules of being a fiduciary or pensions that can’t take too much risk because of their legally binding liabilities.

d. Unique Considerations- This is the catch-all bucket for everything that is not included in the other constraints. Examples include any socially responsible investment mandates such as excluding “sin” investments like tobacco or highly concentrated stock positions for corporate executives and business owners.

3) Identify the Appropriate Investment Strategy that:

4) Carry out the Asset Allocation Process

Based upon your required and desired rates of returns and in conjunction with your constraints, select the portfolio of investments that will work for you, taking diversification and correlations into account. This is done in two steps:

1. Define your Asset Allocation- What percentage of your portfolio will be in stocks, bonds, real estate, and other alternative investments? For example, you could have a stock/bond/real estate portfolio of 40/30/30.

2. Define the Individual Composition of each Asset Class- For example, what percentage of your stock portfolio will be in US stocks vs International stocks and what percentage of each of those buckets will in subcategories such as growth, value, etc. What percentage of your bond portfolio will be in corporate vs government bonds, etc.? What percent of your real estate portfolio will be in multifamily vs office vs retail? There are more subcategories and choices but these are just examples.

5) Purchase your Investments

After you have selected which asset classes you will invest in and in what percentages of your overall portfolio, it is now time to choose and purchase the individual investments that will constitute your overall portfolio. Stocks and bonds can be bought through a financial advisor or you can do it yourself at an online discount brokerage, such as Interactive Brokers, Merrill Edge etc. Real estate investments can be purchased directly through your local realtor, through a REIT purchased at a brokerage firm or through a real estate investment firm that syndicates equity investors to invest in larger properties.

6) Evaluate your Portfolio Performance Periodically

The first step is to determine how often you will evaluate portfolio performance. It could be weekly, monthly, quarterly, etc depending upon your preference. The next step is to measure the performance of your individual investments vs the appropriate asset class benchmark to determine if you should make any changes. For example, if you own a large-cap growth stock and it is underperforming the large-cap growth index it may be time to reevaluate.

7) Rebalance the Portfolio as Needed

Your investment portfolio will change over time due to market fluctuations and withdrawals (if any). The purpose of having a diversified portfolio is to decrease the volatility of your returns. The purpose of having an investment policy is so you stick to your asset allocation and use rules instead of emotion to force yourself to have the discipline to sell high on investments when they exceed your target allocation and buy low when you are under your target allocation. You can either choose to rebalance your portfolio on a periodic basis (monthly, quarterly, etc) or do so when your portfolio allocations exceed certain thresholds such as if your stock portfolio goes 10% beyond your targeted allocation. Both are viable strategies.

I hope this outline will provide you enough to get started. But remember- life is a journey, not a destination. A long list of significant life events can drastically alter your journey. A few examples include marriage, divorce, having children, getting a raise, losing your job, or unexpected medical expenses. The list can go on and on but the process for determining your IPS remains the same. It is an iterative process, simply add in and account for your new circumstances and continue the process. Best of luck to you on your voyage!

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