How to Write Your Very Own Investment Policy Statement – Getting Started

In his book, Optimal Investing (Affiliate Link), Scott Frush writes this about the importance of having an Investment Policy Statement:

Much like a blueprint for building a house, an Investment Policy Statement serves as the blueprint for building your optimal portfolio. This policy is crucial to the long-term achievement of your specific financial goals. First and foremost, an Investment Policy Statement helps you learn more about what your needs and priorities are, how to best address them, and the risks involved with investing. Secondly, this policy allows you and your portfolio manager (if you elect to employ one) to gain a better understanding of your objectives and constraints and how to best manage your portfolio to accomplish your specific financial goals.

A written Investment Policy Statement will not alone guarantee success in protecting and growing your optimal portfolio. Rather, it will shelter your portfolio from ad hoc revisions, made by either you or your portfolio manager, from a sound long-term asset allocation policy.

Basically, an Investment Policy Statement should explain why you’re investing (your goals) and what you are investing in. Why is this important? Because human nature tends to take over when times get tough and might cause you to make changes to your investment plan based on emotion rather than sound logic. Being able to pull out and read through your Investment Policy Statement (IPS) will give you comfort and just might keep you from making a serious mistake.

Continue reading How to Write Your Very Own Investment Policy Statement – Getting Started

Should You Manage Your 401(k) Yourself?

This question comes to us from a guy I have known my entire life:

I read your article the other day Should Portfolio Rebalancing Be Considered Market Timing? and it got me thinking about my 401k balance. I’m turning 40 next month and am looking at my 401k balance, thinking should someone with my level of investment knowledge be managing this account?

Over the years, it’s grown to a significant amount without any research on my part, I just deposit money spread it over several funds and watch it grow. Rebalanced the 401k last year using a financial engine software supplied by my company, but as it turns out my market timing was bad. Overall, I think the diversification across 12 mutual funds is good, but still wonder if I could maximize gains or choose better times to rebalance the portfolio.

I’m guessing that most people manage their 401k’s themselves, but should they? Especially once the 401k reaches a higher balance as there’s so much more growth potential. Is there any added value to authorizing a professional to manage your 401k?


Wow! I can’t believe one of my friends is turning 40!!!!!

First off, just because you made changes to your plan and the market went down, does not mean you made a bad choice. Remember, we’re looking long-term here so we really shouldn’t care what happens right now. No, it’s not fun to watch a 401(k) balance drop but we have to look at the big picture.

If you have a relationship with an advisor, they might be willing to take a look at your plan. However, if they are commissioned-based, I wouldn’t expect them to spend a lot of time analyzing your plan and making suggestions since they don’t get paid for that kind of work.

There are lots of fee-only financial planners out there that will offer advice on 401(k)s. You’ll have to pay an hourly fee but it might be worth it if you think you need a second opinion. I will tell you that lots of planners are just going to run your fund choices through Morningstar or something similar to Financial Engines, so you’ll most likely get the same results as you already got when you ran the numbers yourself. A good planner will also help you assess your risk tolerance and educate you on the best asset allocation for you based on your risk tolerance, age, and time horizon. So, there could be some value added there. Just be prepared to spend $150 – $300 for the advice.

I’m not sure it is necessary for you turn over management of your 401(k) to a professional. Asset allocation is pretty cut and dry and can be easily grasped by most people by reading any number of books. I realize that reading a book on asset allocation is probably not at the top of most people’s list of desirable activities but I honestly believe that EVERYONE should have a basic grasp of investing and asset allocation. Fortunately, there are books out there that are very easy to understand and are actually interesting. One of the best books I know of is a short little book called The Coffeehouse Investor (Affiliate Link), which I read in a couple of hours. It will give everyone a basic understanding of asset allocation and investing. EVERYONE should read “The Coffehouse Investor.”

If you want something beyond that, I would suggest taking a look at The Intelligent Asset Allocator (Affiliate Link) by William Bernstein. It’s a little on the dry side but is still a very good book and will definitely give you a better understanding of asset allocation.

So, those are my thoughts on 401(k) management. What do you guys think? Should people hire a professional to manage their 401(k) account? Why or why not?

Why Stocks Are for the LONG Term

My company just sent out the performance numbers for all of the top indexes we follow; they do this each month to keep all of us in the know about how the market is performing. I was really surprised by what I saw.

I knew stocks were down year-to-date, but I didn’t realize by how much stocks have underperformed over the last 10 year period. The S&P 500 Index (large cap stock) has returned only 3.89%, and the Russell 3000 Index (total stock market) has returned 4.28% for the 10 years ending 4/30/08.

Of course that’s before taking any taxes or fees into account, meaning most people’s returns – even if they had their stocks sitting in a stock index fund from April 98 to April 08 – essentially were flat and certainly didn’t beat inflation.

What’s more, the Lehman US Aggregate Bond Index annualized a 5.96% return over the same period, outperforming both major US stock indexes.

Now of course if you’re only looking at the last 5 years of performance, stocks have performed rather well – 10.62% for S&P 500 and 11.40% for Russell 3000. Bonds were 4.37%. Then again over the last 1 year, both stock indexes have negative returns (-4.68% and -5.15% respectively) while bonds are up 6.86%.

We must keep in mind that stocks are down over the last 10 years mainly because 1998 was near the peak of the internet stock bubble, which promptly burst soon after. If we look at returns over longer periods such as 15 and 20 years, returns are solidly positive (I don’t have that data, or I would provide it).

The point is that investing in stocks is truly for the long term. People like to talk about the average 8-12% return over 5+ decades, but the truth is that stock market indexes do have long periods of negative and/or flat growth during their historically upward ascent. You might get lucky over a 3 or 5 year period, but the best thing to do is to invest in stocks only when your savings goals are truly long term.

But what exactly constitutes long term? If you are saving for a house or car or vacation or anything that you want to purchase within the next 10 years, you would be better off to invest in mid-term investments (bonds, 5-7 year time horizen) or CDs, savings accounts, or money market funds (1-4 year time horizen). If you’re shooting for something in the 8-10 year range, go ahead and bet on stocks if you like. But remember, it is a gamble.

More from Meg at The World of Wealth

Should Portfolio Rebalancing Be Considered Market Timing?

I’m in the midst of reading a new book by Christopher Jones titled The Intelligent Portfolio (Affiliate Link).

Jones, who is the Chief Investment Officer of Financial Engines, writes that people who invest using a fixed-proportion portfolio (i.e. 70% stock/30% bond portfolio) are essentially market timing when they rebalance their portfolios. Why? Because the act of rebalancing requires the selling of an asset class that is “overvalued” and using the proceeds to purchase another asset class that is “undervalued.”

I’ll have to admit that I never really looked at in this way but I can see his point. I always considered rebalancing as a prudent way to limit risk. If a person desires a 70/30 portfolio of stocks and bonds, over time the percentage of their portfolio that is exposed to stocks will increase as stocks typically appreciate faster than bonds. Take a look at the graphic below to see what I mean:

A Portfolio with No Rebalancing

Assuming a 10% rate of return for stocks and a 5% rate of return for bonds, in ten years this portfolio would nearly become an 80/20 portfolio. For a personl only desiring a 70% exposure to stocks, an 80% allocation would seem inappropriate.

So my question to you is:

Is portfolio rebalancing the same thing as market timing?

I’m not far enough into the book to tell you what the author’s view on this topic is. I’ll be covering more of this book in the near future.

Investing For the Long Term – What’s a Good Portfolio Allocation?

I received this email from a reader:

I was wondering if you could do a post on what you think would be a good long term stock portfolio allocation. I saw an earlier post of yours on Kiplinger’s 2008 recommended allocation and tweaked it a little to create the allocation below. Like Kiplinger’s allocation, I stuck to only equities, intend this to be a long term portfolio (i.e., no withdrawals for at least 15yrs+) and stuck with only Vanguard funds because they’re generally the cheapest. Obviously, an emergency cash cushion would be maintained, I just didn’t include that in this allocation. I also didn’t include a bond position even though I’d keep a small bond allocation. I really wanted to just concentrate on a good mix of equities only.

I’d appreciate any thoughts you or your readers might have on a good equity allocation.


Proposed long term portfolio:

30% – Large-Cap Domestic / Vanguard 500 Index (VFINX)
10% – Small-Cap Domestic / Vanguard Small-Cap (NAESX)
10% – Mid-Cap Domestic / Vanguard Mid-Cap Index Fund (VIMSX)
20% – Large-Cap Int’l / Vanguard Total Int’l Stock Fund (VGTSX)
20% – Int’l Emerging Markets / Vanguard Emerging Market Stock Fund (VEIEX)
10% – Real Estate Investment Trust / Vanguard REIT (VGSIX)


Based on the information you gave me, I see nothing wrong with that allocation. If this is a lump sum you are investing, don’t forget about the possibility of using exchange-traded funds. Vanguard has ETFs for each of those asset classes (for more information, click here).

The main thing I would suggest is that you make sure you stick with your allocation by rebalancing every year or so—depending on how far your portfolio deviates from your chosen allocation plan.

Finally, if you are interested, you might want to check out my post, Building a Portfolio for Retirement, that I did a few weeks ago. This is a diversfied portfolio that invests equal amounts in seven different asset classes. The portfolio was based on the work of BYU professor, Craig Israelsen.

It’s Not Always Necessary to Shoot For the Moon

In a paper on the importance of having an investment policy statement*, Larry Swedroe gave the following example that illustrates that it’s not always necessary to shoot for the moon when investing to meet a goal like retirement:

In a discussion with a new client, a 55-year-old investor I learned the following:

  • He currently had $2.5 million of net assets.
  • He wanted to retire in 10 years.
  • He was a long-term investor with a high tolerance for risk, evidenced by his current portfolio’s equity allocation of almost 100%.

When asked how much money he felt he would need to comfortably retire. He responded: “$4 million.” I then asked him whether his lifestyle would change much if instead of $4 million he ended up with $6 million. He said: “No.” I then asked him if his lifestyle would change if he ended up with just $3 million. He said: “Yes, I would have to keep working.” Clearly the reward of his ending up with more dollars than his goal was far less than the pain of ending up with less. In other words, while he had a long investment horizon (the second to die life expectancy between he and his wife was about 30 years), and he apparently had a high risk tolerance (as evidenced by his current 100% equity allocation), he was clearly a risk averse individual. I then showed him that to achieve his $4 million goal in 10 years, including the savings from his salary over that period, he would need to earn less than the rate of return on a money market account. He didn’t need to take the risk of an all-equity portfolio to achieve his objective. Financial economists would say that his utility of risk was very low. The marginal benefit of the upside was very low, while the pain of a downside outcome was severe. He ultimately decided to substantially reduce his equity allocation. An irony about investing is that the very people who can most afford to take risk (the very wealthy) have the lowest utility of risk, and therefore the least need to take it.

Since this guy’s goal was $4 million and he already had $2.5 million, he didn’t need to take on the unnecessary risk associated with a 100% stock portfolio. Of course not everyone has that option. For people who have a small retirement plan balance, they will need to 1) invest more, 2) invest more aggressively (but not stupidly), and 3) accept the volatility.

I think this example shows the importance of having a goal to shoot for when saving for retirement. If your goal is a $4 million retirement balance by age 60 and you are now 30 and have a balance of $100,000 in your plan, you can calculate how much you need to save per year based on your expected rate of return as the table below shows.

Retirement Savings and Rates of Return

NOTE: I ignored inflation, taxes, and contribution limits in my calculations.

I don’t know too many 30-year olds that could afford to sock away $4,500+ per month. Therefore, it’s important when you are younger to take advantage of the better returns usually offered in stocks because you have time on your side, which lessens the impact of volatility. In other words, if you have a few bad years, you have DECADES to make it up.

One other thing is that if you know what your retirement goal is, you can gauge your performance to see if you need to make any changes. For example, we can calculate where you should be at age 35, using the numbers from the table above:

Retirement Savings and Rates of Return

It’s important to note that I used straight-line appreciation when calculating the growth. In real life it would be much more variable than that. That said, the last table could give you an idea of where you should be based on your goal and your required rate of return. Then, as you get closer to retirement you can assess your situation to see if you can adjust your allocation and put less of your portfolio at risk by moving it into more conservative asset classes, which is what Larry suggested in the story above.

This is a pretty broad topic. Just putting this post together has given me more blog post ideas, which I’ll be adding later. If you have questions or comments, please leave them below.

*I plan to make that paper available as soon as I get it formatted properly.

MBN Group Writing Project: Yearend Money Moves – Time to Rebalance Your Portfolio

This entry is my contribution to the MoneyBlogNetwork group writing project. This project is focused on year-end money moves.

It’s time to start saying goodbye to 2007 and get ready for 2008. The yearend is a great time to make adjustements to your portfolio. We call those adjustments “rebalancing.” The easiest way to understand the rebalancing process is with an example.

Let’s say you had the following portfolio at the beginning of the year:

Your allocation calls for you to hold equal allocations of each of the ten sectors of the Dow Jones Total Market Index. So, each sector would represent 10% of the total value of the portfolio.

On December 16, 2007, the portfolio looked like this:

As you can tell, some of the sectors are worth considerably more now than they were at the beginning of the year, while other sectors are worth a lot less. In order to keep our allocation the same, we need to rebalance by selling off some of the sectors that performed well and buying more of the sectors that did poorly. Now, this might run counter to your emotions, but selling “good” investments and buying “poor” investments is exactly what you need to do in order to keep your emotions in check.

How you go about rebalancing depends on following:

1. Commissions charged on the account. Do you have to pay commissions based on the transaction? If so, you might want to limit the number of trades you do since transaction charges can really eat into your returns. On the other hand, if your account is charged a fixed amount each year, such as FOLIOfn, you can most likely reallocate without incurring extra fees.

2. Whether it’s a taxable or non-taxable account. Since transactions will result in capital gains, it might be to your advantage not to rebalance if your current allocation isn’t much different from your target allocation. A general rule of thumb is to reallocate when one asset class or sector is 5% higher or lower than the orginal allocation. If your acount is held in an IRA, then taxes aren’t a concern.

The first step in reallocating a portfolio is to calculate how much over or under the current allocation is from the target allocation:

If your account is held at FOLIOfn, you can rebalance your portfolio with the click of a button. If not, you’ll have to do a little more work by selling off some of the overallocated funds and buying more of the underallocated funds in order to bring you back to your original allocation.

Here’s an example of what your portfolio might look like after reallocation:

If you’ll notice, I didn’t bring this portfolio back exactly to its original allocation. I left IYK alone since it was only $200 off from its original allocation. If you had to pay commissions on each trade, you might decide to even less reallocating than I did by only reallocating the top two and the bottom two.

I can’t emphasize enough how important reallocation is. Sectors and asset classes fall in out of favor all the time. By selling off those sectors that outperform and buying more of the sectors that underperform, you essentially “lock in” your gains. Yes, there’s always the chance that the poor sectors will continue to perform poorly, but there’s also the chance that the better-performing sectors will underperform. As the chart below shows, it’s incredibly difficult to know which sectors are going to perform the best from year-to-year:

Dow Jones Total Market Index Sector Total Returns 1992 - 2006
Click to view in a larger format

Hopefully, I given you the basics on rebalancing your portfolio. I welcome any questions or comments you might have.

Now, here are the links to the other posts in the MoneyBlogNetwork’s Yearend Money Moves Series:

Blueprint for Financial Prosperity – Dumb Year End Money Moves

FiveCentNickel – Clearing Out Your House For Fun and Profit

Consumerism Commentary – Use Your Flexible Spending Account Before It’s Too Late

NoCreditNeeded – Jump Start Your Debt Reduction Using Christmas Gifts and Year End Bonuses

FreeMoneyFinance – Make Your Charitable Deductions Before Year End

MightyBargainHunter – Grab Some Year End Bargains

Get Rich Slowly – Paycheck and Witholding Calculators for Year End Money Moves