Sunday, March 15, 2020

An Investor Policy Statement Helps Ride Out Coronavirus Stock Market Turmoil

The S&P 500 Index has dropped 30% or more, as of this writing, since its recent high in February. But I haven't checked my portfolio since early January. Why? I have an Investor Policy Statement that guides me through turbulent market fluctuations like this and I have more important things to focus on right now. 

Flowers at Salesforce Park in San Francisco, March 2020.

I've been in self-quarantine for a week since returning from a trip to San Francisco where I may have been exposed to the Coronavirus. My wife has a compromised immune system. As a precaution, she is staying nearby at our friends' Airbnb house that was fortunately not in use. We're focused on staying connected while she is living elsewhere during an unsettling time, avoiding contact with others so she can return home, and obtaining necessary supplies. 

The Coronavirus has disrupted life as we know it and sent financial markets into chaos. Unlike the burst financial bubble of 2008, day-to-day life has been completely upended. People are worried they or family members may catch the virus, get sick, and possibly die. Non-essential businesses are closed and people are at home, waiting for this to end.
 
I've read many posts in the financial groups to which I belong on Facebook by people complaining about how much their portfolios are down and how they are selling stock funds and buying bonds. Or they purchased stocks or funds on the dip only for the market to go lower, causing them to sell at a loss. Or they are asking what they should do. Some are too young to have experienced a bear market before and think they will never recover what they lost. How does one know what to do in times like this? 

I know because I wrote an Investor Policy Statement back in the summer. Panics or stressful situations of any kind can impair the mind's ability to make good decisions. The time to make important investing decisions or decisions of any kind, for that matter, is when you are calm, relaxed, and can think clearly, not in the middle of a crises, with the walls closing in around you. That's why it's important to make an Investment Policy Statement. Never heard of one before? Neither did I until I read this post by the Whitecoat Investor. It's basically a roadmap you write for yourself to follow for your finances rather than making decisions based on the news of the day.

Thanks to the post, I learned why a policy is essential to have and decided to document my investment decisions. I documented why I decided to invest in the funds that I did so that I would not second-guess myself when the market drops 30% or 50% or more as it did in 2008. An IPS is also for non-crisis times. It's easy to forget why you decided to invest in something five or ten years ago...or longer. That's particularly true when there is a panic and most people are running for the exits. 

So what is an Investment Policy Statement? An IPS is a document in which you write down what your goals are and how you are going reach them. They can be both financial and non-financial goals. It helps to write down why you have  particular financial goals as circumstances may change over time. You can change your goals to match. An IPS can be as short and broad or as long and detailed you like. The Whitecoat Investor has 7 sections in his policy. My IPS has five sections. It depends on your own financial situation. My plan includes:
  1. Goals
  2. Emergency Fund
  3. Investing
  4. Asset Allocation
  5. Retirement Drawdown Strategy

Entire books have been written about each one of these topics. This is an overview. 


Goals

In the Goals section, I document:
  • How much I want to accumulate for retirement. 
  • The percentage of my income I will save each year to reach that goal.
  • The age at which I want to retire or begin reducing the number of hours I want to work.  
  • The expected income I will have at retirement from investments, Social Security, pension, etc.
  • The kind of life I want to live and how my investments will help me to do that.

Emergency Fund 

The Emergency Fund Section is where I document:
  • How many months of expenses I want to have in a bank or money market account in case of job loss or reduced income. 
  • That the money is not to be invested in anything else, such as an index fund. Many people prefer to invest their emergency fund. I do not. I don't want my emergency fund to drop by 30% or more during a financial meltdown, especially when I need to live off of it. 
  • This section also states that I can't use the emergency fund to go on vacation or pay for regular home maintenance costs. 

Investing

The Investing section discusses the overall investment strategy. Again, this is important to document so you aren't wondering in the middle of a panic why you made an investment decision years ago. You can review it to remind yourself. Mine discusses:
  • What percentage of my income I will save and invest each year. 
  • It states that I will prioritize funding tax-sheltered accounts, such as 401K, 403B, 457B, IRA, Roth IRA, etc. over taxable brokerage accounts. 
  • I state that I select low cost index funds or equivalent exchange traded funds (ETFs) to reduce expenses, which are a drag on returns. 
It can also specify the investment return goal and the amount of risk you are willing to take. This helps you decide which funds you choose based on the return you expect and how much risk you can accept. If you invest in real estate or other assets, you can discuss that.

Asset Allocation

This where you get into the details of your selected investments and why. If you invest in real estate, you would include it and how much of your assets are dedicated to it. For Bogleheads like me, you might have a Three Fund Portfolio that looks like this: 
  • 70% Vanguard Total Stock Market Index
  • 15% Vanguard Total International Stock Market Index
  • 15% Vanguard Total Bond Market Index

You may have many more investments. In this section you also explain to yourself why you are choosing this allocation. For example, I note that because of a partial pension, I have decided to choose a higher stock fund allocation than I would if I did not have a pension. A younger person may choose to be 100% invested in the Total Stock Market Index. An older person would likely have a much higher bond allocation as they are closer to or in retirement. 

This section is where you can also note how you will re-balance your portfolio. Mine will be done with new 401K contributions instead of selling and buying existing shares. I do have a provision that if the market drops by 20% or more, I may choose to sell bonds and buy more of the stock funds. At this point I have not done that. My 401K contributions are still hard at work for me, buying at lower prices. I'm satisfied with that for now.  
 

Drawdown Strategy

The Drawdown Strategy is where you write down the order in which you will draw from your accounts. Many people focus so much on accumulating that they aren't sure what to do once they have reached their goals. Had they thought about a drawdown strategy earlier, they may have planned and invested differently, retired earlier or worked even longer. You want to get this right so your money outlasts you.  

Financial planners advise that you withdraw funds from accounts in a specific order such as drawing from taxable accounts first, Roth accounts next, then IRAs, 401Ks, and similar accounts. This way you don't have too high a tax burden early and reduce the size of your portfolio unnecessarily.    

For example, you don't want to withdraw all of your money from an IRA or 401K plan the day you retire because you will pay a tremendous amount in taxes. It's best to withdraw it over time so the portfolio continues to grow and you minimize your tax burden. 

This section is where you also address when you will begin to receive Social Security benefits. If you begin doing so early, you will reduce your monthly Social Security benefit. If you wait until 65 or 67 or whatever the age is when you are eligible to receive full benefits, you will maximize your monthly payment. 

There are other factors to consider as well. If you are in good health and come from a family of long-lived individuals, you may consider delaying Social Security benefits to maximize your benefit. If you are in poor health, it may make sense to begin receiving benefits sooner, rather than later. A bigger payment later isn't useful if you aren't alive to receive it. Writing it all down, helps you see the big picture and make a plan so you aren't trying to keep it all in your head years later or when the market drops by 50%. 

The final section of the Whitecoat Investor's IPS is that all changes must wait three months before they are implemented. I think that's great advice. It prevents us from making decisions based on knee-jerk reactions to the news of the day rather than thinking of the long term. I did not include that in my written, as it's an unwritten rule for me, but will add it.

I'm optimistic that scientists will find treatments or a vaccine for the Coronavirus. Hopefully the economy recovers and people who have lost jobs or incomes will return to work quickly. 

In the meantime, I'm not panicking about my portfolio. I have an Investment Policy Statement that made sense 6 months ago and makes sense now. I wrote it for the long-term and will adjust when necessary. It allows me to focus on my work and staying healthy, rather than being distracted by every dip or jump of the market. 

I highly encourage that you write yourself and Investor Policy Statement for peace of mind when things settle down. Make  choices that will help you prepare and ride out future downturns. 

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