Do You Havean Investment Policy Statement?
Roger P. Levin, DDS; Michael C. Smith, MBA, CFP®
It is good to be passionate about investing, but when your passions guide your investment decisions—watch out. Many professionals, including dentists and specialists, experienced heavy losses in the stock market during the early part of this decade because of emotional investing. How could so many people seemingly abandon the principles of logic and common sense when it came to the stock market? The book, Extraordinary Popular Delusions and the Madness of Crowds,1 provides an interesting historical look at such irrational exuberance in the past, including the tulip mania of the 1600s when tulips traded at a higher price than gold.
A Time of Irrational Exuberance
Similarly, in 1999, companies could begin trading on a stock exchange with an initial public offering price in the teens or low twenties. Because of a version of tulip mania in the late 1990s, these companies—although having never turned a profit in their short existences—could see their stock price rise to $150 to $200 per share. This behavior led to investors losing focus on their investment strategy (assuming there was one) and investing with emotions rather than pursuing a disciplined approach.
How did a minor loss turn into a substantial reduction in overall wealth? Again, many of the dentists with whom we have spoken indicate that their emotion ruled the day rather than adherence to a disciplined policy. If one bought a stock at $60, saw it move to $140 and didn’t sell at that time, the dentist believed that he or she owned a $140 per share stock. Once the market started moving down, people who owned this kind of stock, believing that the stock was worth $140, watched the stock go below $100, under $75, then $50, and finally ended up trading at $4 per share. If emotional investing and the lack of a discipline led many investors to lose more money than they should have, what can be done to ensure that this does not happen again?
Striking the Right Balance
Creating and following an investment policy statement (IPS) is key to takinga long-term, disciplined approach to financial success. An IPS provides a framework on which investment decisions are made. It outlines your investment philosophy, the means you will take to achieve your desired rate of return, the level of risk you are willing to incurany unique circumstances (eg, impending divorce, care of child with special needs, etc), tax considerations, and liquidity needs. Once these are documented and understood, an asset-allocated portfolio can be constructed that considers all of these factors. An IPS is similar to a business plan, except the business is not your practice, it is your investments.
At Levin Financial Services, an IPS is prepared for every client whose assets we manage. Targeted weighting along with a clear policy for rebalancing portfolios is used to create the IPS. For every investment in your portfolio, there should be a clear understanding of your exit strategy, whether it relates to price, time, percentage of the portfolio, or some other factor. This should all be outlined in the IPS, and if adheredto, will help prevent significant losses in the future.