Editors' pick: Originally published April 6.
Winston Churchill said, "He who fails to plan is planning to fail." In the investment world, many individuals simply invest with no cohesive plan guiding their actions. Many people simply put aside money, invest in what strikes their fancy at the time, and see what happens.
Professional investors know the value of creating and, more importantly, adhering to an investment policy statement. An IPS is a written document that summarizes an investor's return objectives and risk tolerance, specifies the investor's time horizon and details applicable constraints such as liquidity needs, tax considerations and special circumstances.
Perhaps the most important element of an IPS is that it specifies an investor's target asset allocation -- that is, the mix of assets (stocks, bonds and cash) that is appropriate for the investor given his or her goals and objectives, constraints, risk tolerance and unique circumstances. An IPS is a guiding document that is particularly valuable in down markets when investors often question their course of action and want to "sell out of stocks."
It is common practice for investment advisers to consult with individual clients and create a unique IPS for each client. We all have different goals and objectives and, perhaps most importantly, different risk tolerances. Some of us may have the ability to bear risk, but not the willingness to do so. There is an old investment adage that says "you can eat well or sleep well." Those willing to bear more risk have a better chance to eat well in the long run. On the other hand, those who bear less risk find they have fewer sleepless nights.
The best time to create an IPS is when we are in a "Goldilocks Market" -- that is, when the market is neither too hot nor too cold. Many investors suffer from recency bias -- the propensity to overweight the immediate past and expect it to continue into the foreseeable future. A raging bull market may lead investors to believe that they should bear more risk and develop an investment strategy that is overly aggressive. On the other hand, in the depths of a bear market investors may become overly cautious.
The current market, it seems, is "just right" for creating an IPS.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.Robert R. Johnson is president and CEO of the American College of Financial Services.