Put it in writing!

With recent market volatility, it’s a good time to remind yourself exactly why you own all those stocks and mutual funds. And the way you do that is by drawing up an investment policy. Investment policies are used by institutional investors to make sure that they and their advisers have a clear understanding of what long-term strategy should be pursued and how much risk should be taken.

By spelling out your investment strategy, it should help you to avoid panicky decisions when the market drops. Investment policies consider taxes, investment time horizon, attitude toward risk, ability to recover from losses, and investment diversification. The policy answers these questions:

You might consider separate savings strategies for each goal, because they involve different time horizons, and therefore you should take different degrees of risk.

Depending on each savings goal, you will want to divvy up your money among stocks, bonds, and cash investments like money-market funds. This mix determines your long-run investment return and its short-run price gyrations.

Generally, if you are 10 or more years from retirement or sending kids to college, you will want to be mostly in equities, in an effort to earn higher returns. But if your goals are closer, go lighter on stocks and favor low-risk investments.

By glancing back through history, you can get an idea of how your portfolio is likely to perform and whether you have a mix that you can stick with in rotten markets.

Generally you will want a mix of stock and funds that provide broad U.S. stock market diversification, plus maybe a 20% or 30% stake in foreign stocks. What if you want to stray from this mix? Write down what strategy you will use and how big a bet you are willing to make on any one market sector or one stock. That way, you will be well aware of the risks you are taking.

The eventual size of your nest egg depends upon the investment returns you earn and the money you stock away. Don’t lull yourself into complacency with optimistic projections. Inflation and taxes will eat into your performance.

Dividends and interest will provide some spending money. But consider keeping several years of living expenses in a money market or short-term bond fund. That will provide you with a cushion in case a bear market hits the rest of your portfolio.

If you are still working, think about how you will tap your portfolio if a financial emergency strikes. You might hold some cash or short-term bonds to cover emergencies, while making sure you have access to borrowed money through credit cards, margin accounts, and home equity loans.

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Copyright © 2000 Econ401 All rights reserved.
Revised: November 30, 2000 .