The economic and investment environment this year has been challenging, unlike previous times when market conditions may try your patience in maintaining your long-term target asset allocation. To help keep emotions out of your investment decisions and making futile market timing decisions, it is important to have a personal Investment Policy Statement (IPS) to keep you on track to avoid making rash decisions. Included in an IPS are the following key investment constraints to guide all your investment decisions.
1. Time Horizon
The longer the time period to reach your financial goal, the more aggressive you can be with your investments. With time on your side, you can more easily weather short-term downturns in the market knowing that the long-term results are what you’re targeting. A longer time horizon means you can invest in such asset classes as equities and real estate. Over longer periods of time, usually five years or more, these asset classes typically perform well, even with some ups or downs in the meantime.
If you are already retired, don’t make the mistake of getting too conservative with your retirement funds, especially during these times of high inflation. Even in retirement, you should plan for a time horizon of at least ten to fifteen years beyond life expectancy. Failure to do so may result in your money running out before you do.
2. Income Taxes
If you are in a high federal income tax bracket, you may need to include some tax advantaged investments in your portfolio. This may include municipal bonds, savings bonds, or annuities. You may also want to favor stocks, mutual funds, or exchange traded funds that pay little to no dividends, or that pay dividends that qualify for the lower capital gains tax rate.
It is important to remember that just because you are in a high tax bracket, doesn’t necessarily mean you need to put all of your funds in tax favored investments. What counts is what you keep in your pocket after Uncle Sam is done with you. If a fully taxable investment can provide you with more spendable money after taxes than a tax-free investment, then invest in the taxable investment.
The key point here is to make investment decisions based on their economic benefits and fundamental soundness not based solely on the tax benefits. Ideally, you want to accomplish both.
Also, if you have a taxable portfolio, don’t be afraid to take losses on investments that didn’t pan out or are temporarily down. Many times, investors say they will wait until it comes back then sell it. In most instances, it would be better to realize the loss, deduct it on your income taxes to help reduce your tax liability. If it is an investment you really want to keep, wait 30 days, and buy it back at the lower price. It’s also good emotionally as you don’t have to look at that loss each time you check your portfolio.
3. Risk Tolerance
This is the hardest investment constraint to quantify but it is the most critical in creating an investment portfolio that will achieve your financial goals. In some cases, the amount of risk you can assume with an investment is dictated by your time horizon. If you have a short time horizon, you know you cannot assume too much risk with your investment because you will need the funds within a couple of months or years.
The best way to view risk tolerance is to understand volatility, which is the fluctuation in the value of your investment. For most investors, the volatility of an investment is what will determine the level of risk you are willing to assume with an investment. For example, for any one given year, equities are generally considered to be more volatile than bonds and bonds are generally considered to be more volatile than money market funds. The less volatile an investment, the greater assurance you have in achieving your goal in the exact time frame you desire. The shorter your time horizon, the less volatile your investments should be. This does not mean you may or may not have been better off in a more volatile investment, but the primary objective is to reach the goal.
By clearly identifying these key investment constraints in your IPS before making any investment decision, you will be able to construct a better investment portfolio that more closely matches your goals and objectives, and hopefully, keeping your emotions out of the investment process.