Use an Investment Policy Statement to Bring Discipline to Your Investing Process
The majority of advice given to individual investors relates to PICKING – which stocks to buy, which mutual funds to choose, which online broker to use, which adviser to hire, which newsletter to subscribe to, which trading strategy to use, and on and on and well, you get the picture.
Very little attention is paid to the things that are more important, like developing a strategic investment plan: evaluating risk tolerance, choosing an appropriate mix of assets, controlling costs, etc. While these considerations are all important drivers of investment success, a singular focus on picking often causes performance to suffer.
In order to promote the disciplined execution of an investment strategy, institutional investors like pension plans, foundations and endowments often draft an Investment Policy Statement (IPS). This document formally outlines the investment objectives, philosophy, boundaries and procedures for managing the portfolio so that the people who are making the investment decisions don’t stray from the plan’s objectives.
Individual investors can get a similar benefit by drafting their own Investment Policy Statement. A brief, well thought out IPS can help an individual investor stay focused on his goals and systematically resist the natural human tendencies that seriously harm investment returns.
Individual Investors Often Misbehave
There’s an abundance of research on individual investor behavior, and very little of it is flattering. Barber and Odean’s landmark study, in which 66,465 household accounts were examined from 1991-1996, found that individual investors trade too frequently, thus hurting their returns.
The most active traders in the group underperformed buy-and-hold investors by more than 7% per year. The average investor’s returns lagged a buy-and-hold portfolio by over 2% per year.
According to the study, the root cause of this behavior was overconfidence, a trait that was especially pronounced in men. Specifically, investors were unjustifiably confident in their ability to predict the future movements of the overall stock market or a particular stock, and they invested accordingly. Unfortunately, they were frequently wrong.
Similarly, independent researcher Dalbar Inc.’s 2012 version of its Quantitative Analysis of Investor Behavior study examined the returns of mutual fund investors from the beginning of 1993 through the end of 2012. The study found that the average US equity investor earned an annual return of 4.25% compared with the 8.17% annual return of the S&P 500.
The sharp difference in performance, according to the study, can be attributed largely to investors bailing out during declining markets (selling low) and bailing back in following a market rebound (buying high). The study doesn’t pinpoint a single cause for this common behavior, but it usually occurs when investors overestimate their ability and willingness to handle big market declines, misunderstand the risk-return tradeoff, or seek safety in numbers through “herd” behavior.
How an Investment Policy Statement Can Help
Fortunately, there are steps that DIY investors can take to counteract their destructive behavioral tendencies. First, it’s important to develop an investment plan consistent with your risk capacity, which is your need, ability, and willingness to take risk.
When unsure whether a certain level of portfolio volatility is acceptable, it’s prudent to err on the side of conservatism. The worst time to discover your risk tolerance is during a market decline. When determining your target asset allocation, it’s also a good idea to specify events that would trigger a portfolio rebalancing. Without specific rebalancing criteria (e.g., acceptable bands for each asset class), the door is left open for impulsive, emotion-based trading.
Next, formalize your plan in an Investment Policy Statement. An IPS should include your investment objectives, account balances, current income and future liquidity needs, risk profile, target allocation and rebalancing bands, investment philosophy and fund selection criteria, and plans for periodic IPS reviews. Drafting an IPS may seem burdensome, unnecessary or redundant, but without the ongoing help of an investment advisor, this simple document performs the vital role of a bad behavior gatekeeper.
When you’re tempted to abandon your strategy during a market downturn, your IPS will remind you of your core investing rationale and encourage you to stay the course. When you get a hot stock tip from a friend, your IPS will tell you to keep your distance. And when you get your investment account statement at the end of the year, your IPS will provide a valuable performance benchmark.
Your IPS could be all that stands between you and your return-reducing behavioral tendencies; don’t pass up this opportunity to add discipline to your investment process.
Conclusion
By understanding the impact of human behavior on investment returns and devising a disciplined Investment Policy Statement, DIY investors can overcome damaging behavioral forces and increase their chances of achieving success.