Navigating the Investment Landscape: Why Every Dentist Needs an Investment Policy Statement

Navigating the Investment Landscape: Why Every Dentist Needs an Investment Policy Statement

Steven C. Finkelstein, CFP,® and Joel Greenwald, CFP ®:
The Dow is up 400 points one day, down 500 the next. What’s an investor to do? Nothing … at least right now. Periods of extreme volatility are rarely good times for individual investors to make significant changes to their portfolios. Then how can you sleep? Because you’ve done the necessary work, long ahead of time, during calmer  markets, by crafting an Investment Policy Statement which will serve you well during turbulent times. 
 
Recognizing the Basics
Between 1990 and 2010, the S&P 500, which is an unmanaged index of 500 large U.S. stocks and is often considered a proxy for the U.S. stock market, returned 9.14% per  year. The average stock mutual fund investor received a return of 3.83% per year.1 
 
Is that significant? Yes. An investor receiving a nine percent return will double his or her  money every eight years. One receiving a four percent return will double that money every 18 years. It’s hard to get wealthy doubling your money every 18 years. 
 
How could  this be? How could the stock market return more than nine percent a year for 20 years while the average investor in stock funds received a return of less than four percent a  year? This is partly due to fees and expenses, as the S&P 500, an unmanaged index, has no expenses. But by far the largest factor is that many individual investors are ruled  by their emotions: fear, greed, and the other members of such a negative list. In such an emotional climate, rather than buying low and selling high, many  individual investors buy high and sell low. 
 
As the stock market begins to rise out of a bear market, hope and optimism rise. Many investors watch others make money in the market but sit on the sidelines. As the  market continues to rise in a bull market, individual investors start investing, and as the market rises further, they add more. They become more confident; thrilled and finally  at the top of the bull market, they are euphoric and push as much money as they can into the market. They are buying high. 
 
As the market begins to decline into the next bear market, these investors become surprised, concerned, then scared, hopeless, and panicked. At the depths of the bear market, they capitulate and sell, selling low. 
 
Finding Your Investment Strategy Comfort Zone
What’s an investor to do? The foundation for any investment strategy should be an Investment Policy Statement, a written document that governs how to allocate your investment portfolio, including IRAs, brokerage accounts, as well as employer retirement plans like a 401k or 403b. All of the accounts need to be viewed together and  coordinated in order to achieve the best riskadjusted return for the individual’s risk tolerance and financial situation. 
 
Part of the Investment Policy Statement should address asset location, which determines what accounts should hold different types of assets so that the portfolio is  positioned in a tax efficient manner. Most bonds are best held in a tax-deferred retirement account such as an IRA or 401k. Real estate investment trusts and hedge funds  are generally not very tax efficient investments and should also be held in tax-deferred accounts whenever possible. On the other hand, stocks that are likely to generate long term capital gains are best held in taxable accounts.
 
Linda S. Lubitz and Norman M. Boone have helped educate the financial planning profession on the importance of Investment Policy Statements and how to construct them. Some of the major steps in their process, outlined in their book Creating an Investment Policy Statement,2 are:
• Identifying your goals.
• Knowing your time horizon. Individual clients generally have a time horizon that ends with their life expectancy. In certain situations, such as investing for college, the time  horizon may be quite a bit shorter.
• Understanding your risk tolerance. If you cannot abide the risk that is inherent in investing in the stock market, and are likely to bail out during the depths of a bear market,  you need to examine how much money, if any, should be allocated to the stock market. 
• Identifying asset classes that will be used in the portfolio. Everyone is familiar with stocks and bonds, but it often makes sense to use other investment types as well, in  order to decrease volatility. By selecting investments that have a low correlation to stocks, such as alternative investments, managed futures, hedge funds, commodities, and real estate investment trusts, the overall volatility of the portfolio can be reduced while still aiming for a significant target rate of return. 
• Writing the Investment Policy Statement. A written document is more likely to be adhered to during market turbulence, and is an important document to come back to as a  touchstone.
• Monitoring the portfolio versus the Investment Policy Statement. The authors’ work environment includes an investment committee of professionals who meet monthly and  review all investments at least quarterly. They then meet with clients semi-annually to review their financial goals and make sure the investment portfolio remains positioned  to give them the best chance to meet their financial needs. 
 
Many of these fundamental ideas regarding an Investment Policy Statement are articulated in the classic book  Winning the Loser’s Game3 by Charles D. Ellis. When referring to the importance of having an Investment Policy Statement, Ellis writes: 
• “The principal reason you should articulate your long-term Investment policies explicitly and in writing is to protect your portfolio from yourself.” 
• “Helping you adhere to long-term policy when Mr. Market makes current markets most distressing and your long-term investment policy suddenly seems most seriously in doubt.” 
• “The best shields against Mr. Market’s short-term data and distress are knowledge and understanding, particularly of yourself and your own goals and priorities. That is why your carefully considered investment strategies should be committed to writing. Don’t trust yourself to be completely rational when those all around you are driven by  emotion. You are human too.”
• “Such hasty reviews typically result in investors selling stocks after they have dropped steeply in value to buy into bonds and other fixed income investments that will not rise as rapidly as stocks in the next cycle of the equity market and vice versa: buying stocks at, or near, the market’s high when the record looks most compelling. Clearly  such ill timed changes in the asset mix, selling low and then buying high, can be severely harmful to your long-term returns.” 
 
As we saw at the beginning of this article in the Dalbar study, the market returned nine percent while the average investor received a four percent annual return in the 20- year period from 1990 to 2010. An Investment Policy Statement that helps take the emotion out of investing should be a cornerstone of everyone’s financial plan. 
 
References
1. Source: DALBAR, Inc. Quantitative Analysis of Investor Behavior 2011 average equity investor performance was used from the DALBAR study, Quantitative Analysis of  Investor Behavior (QAIB), 2011. QAIB calculates investor returns as the change in assets after excluding sales, redemptions, and exchanges. This method of calculation  captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and other costs, annualized over the period. The Standard & Poor’s 500 Index (“S&P 500”) is an unmanaged index of 500 common stocks generally representative of the U.S. stock market. You cannot directly invest in the S&P 500  indexes. Infl ation is measured by the CPI index. Past performance does not guarantee future results. 
2. Boone, Norman M., and Linda S. Lubitz.  Creating an Investment Policy Statement. Denver, CO.: FPA Press, 2004. 
3. Charles D. Ellis. Winning the Loser’s Game:Timeless Strategies for Successful Investing, Fifth Edition. www.sterlingretirement.com 
 
Some advisory services are offered through AdvisorNet Financial, Inc. Registered Representatives offering securities and investment advisory services through Financial  Network Investment Corporation, Full Service Broker Dealer, Member SIPC. Financial Network, AdvisorNet Financial and Sterling Retirement Resources are not affiliated. 
 
*Steven C. Finkelstein and Joel Greenwald are principals of Sterling Retirement Resources, Inc., St. Louis Park, Minnesota.