Opinion: Policy statement separates emotions from investment plans
In times of market turmoil, investors can be whipsawed by emotions, which can cause them to make investment changes at the wrong times.
There are numerous examples of astute investors who became exasperated after the brutal 2008 financial crisis as the market bottomed in March 2009.
Deciding to move assets into certificates of deposit out of fear, these investors fled the market just before the year-long boom that brought 70 percent returns in blue-chip stocks.
Other investors, frustrated by low interest rates on savings accounts and fixed-income securities, put aside the safety of these low-yielding securities and “chased yield.” They wanted more, which was understandable, but by moving their money to high-yield bonds or stocks with impressive dividends, they unintentionally took on increased risk of losing their principal.
As asset prices swing wildly, fear and passion can push aside the best-laid investment plans. Even professional investment advisers can fall victim to emotional riptides in the market.
The solution is that investors should develop long-term strategic investment policy statements to guide the deployment of wealth toward fulfillment of future goals, much like the investment policies of large institutions that guide pension funds or foundations.
Emotions vs. strategy A carefully developed investment policy statement separates the emotional impulse of the moment from strategic decision-making for the long haul. It brings professional discipline to the management of an individual’s assets. A good investment policy statement begins with an individual’s objectives – the future needs an investor envisions for accumulating assets. Goals might include capital for businesses or professional practices, protection against business reversals or job losses, funding for children’s educations, dreams for retirement years, and trusts or estate plans to provide for heirs. An investment policy must be written down in order to promote discipline and avoid fuzzy thinking about the plan’s objectives.
Fleshing out these objectives takes work. Retirement plans, for example, require individuals to think through expected timing, income objectives, where they want to live, activities such as travel or hobbies, and contingencies for health issues.
A smart policy must take a long-term view covering at least three to five years, the length of a typical market cycle. If a plan is just a set of immediate investment changes reacting to the latest economic headlines, it’s not the long-term policy investors need.
Return and risk Investors and advisers often focus on targeted returns, but a sound investment policy needs objectives for returns and risks – with careful consideration of how much risk an individual can tolerate. In other words, how much could the investor lose in a year and still sleep well?
While there are different measures of risk, standard deviation – the statistical average of changes over time – is a helpful measure for individual investors. There is a huge difference between holding an asset that fluctuates 3 percent a year, plus or minus, versus one that rises or falls 30 percent in a typical year.
If an investment plan focuses only on returns, it works to the detriment of investors who may not realize the risk they are piling on in pursuit of increasing the expected returns.
Managing the portfolio as a whole through asset allocation also is a key issue for the investment policy statement. Investors need to understand the targeted returns and risks for his/her entire asset base – and advisers also need to know their roles within the overall asset management plan. The goal is to make decisions on parts of the pie with an understanding of effects on the whole.
Developing a sound investment policy Individuals should consider working with a wealth management professional who is experienced in developing investment policy statements. This brings third-party objectivity into the process and separates the task of developing strategy from tactical investment decisions due to market fluctuations.
If an adviser pushes against formulating an investment policy statement, that adviser may be too focused on short-term transactions and unable to help an investor achieve long-term goals.
An investor and the adviser, or team, should agree on a level of communication and reporting that satisfies the investor’s needs – as much or as little as desired. The investor should demand metrics and reporting of progress against targeted returns and risk levels. An example would be showing risk/return data relative to benchmarks or peer groups.
The investment policy statement should provide for regular – but not frequent – review and revision. Since typical economic cycles last three-to-five years, evaluating performance throughout a full cycle – or longer -– and updating the plan based on that “long view” is the best approach.
Most importantly, adopting a written policy statement prepares the investor for disciplined execution of the plan over time. Having an individualized investment policy translates what the investor wants to accomplish in life into tangible long-term plans.
With this approach, the investor and their advisers can resist the emotional cycle of fear and passion that could easily take them off track next time the market is up – or down – 3 percent in a day.
K.C. Mathews is a chartered financial analyst and executive vice president and chief investment officer of UMB Bank in Kansas City. The bank operates two Springfield branches.[[In-content Ad]]