Do You Know Where to Go from Here?

By Bill Gallagher, CFP®, MPAS®

“Would you tell me, please, which way I ought to go from here?”

“That depends a good deal on where you want to get to”, said the Cat.  

“I don’t much care where”, said Alice.

“Then it doesn’t matter which way you go”, said the Cat. 

“-so as long as I get somewhere”, Alice added as an explanation. 

“Oh, you’re sure to do that”, said the Cat, “if you only walk long enough.”

I was watching Alice in Wonderland with my daughter recently, and as a financial planner, I couldn’t help but relate the above dialog between Alice and the Cheshire Cat to financial planning and investment management.  To me, this dialog represents why it is so important for individuals to take time to define their life goals and objectives within the context of a comprehensive financial plan and an investment policy statement.  

While the underlying message in the dialog above is true, if you don’t know where you’re going, any road will get you there – it does not get to the heart of the issue as it relates to someone who is trying to plan for their future.  Yes, any road will get you there, but “there” may not be where you want or need to be. 

Those who have gone through the process of designing a roadmap for their goals will most likely achieve those goals more effectively and efficiently than those who do not have a plan.  The road may not always be smooth, and there will be many detours along the way, but with a personal guide in your hands you will be able to navigate around and through those detours to get back on track more quickly than if you did not have a course of action. 

Whether you are in the accumulation stage of saving for a goal (e.g. retirement, education, new home, vacation home, etc.) or are in retirement, and drawing income from your portfolio, it is extremely important that you establish your goals and objectives within the context of a comprehensive financial plan, thereby creating your personal roadmap.  It is also important to ensure that your assets are invested appropriately given your goals, objectives, and risk tolerance.  Investments are tools we use to get from where we are to where we want to be, and to get there efficiently, your investment portfolio should be governed by an investment policy statement (IPS).  

What Is An IPS?

While the financial plan serves as a strategic guide for your life goals, an IPS is a process of implementing your investment program.  Properly aligning your risk tolerance with your goals and objectives will help you deal with any surprises down the road.  I like to think of an IPS as a framework for a well-diversified portfolio through which you can expect to generate acceptable long-term returns, at the level of risk you are willing to accept.  It is within this framework that you consider and define your risk tolerance as an investor.  The importance of fully exploring and understanding your risk tolerance cannot be overstated, as your risk tolerance will specify your overall target asset allocation and will help in establishing the investment guidelines relating to the selection of your portfolio assets.  

What is Included in the Investment Policy Statement?

The principal reason for developing an IPS is to establish a course of action that will be followed through different market cycles.  This includes periods of market volatility when emotional or instinctive responses might otherwise prompt less than prudent actions.  Without such guidelines, research has shown that investors often make investment decisions that may be inconsistent with prudent investment management principles, their financial objectives, and their risk tolerance.  All too often, during extended bull market rallies and severe bear markets, investors take a short-term view of a long-term investment strategy and end up making decisions that can cause irreparable harm to their financial situation.  Having a financial plan and IPS to reference in times of market volatility may help bring your goals and objectives back into focus and remind you of the long-term nature of your investment portfolio. 

Risk & Return

By now many people understand the relationship between risk and return.  In general, for an investor to achieve above-average investment returns, he or she must be willing to accept a higher degree of risk.  While this relationship between risk and return exists, for most investors, “risk” has more to do with the potential for the loss rather than for the potential of investment gains.  Too much loss triggers a fear response that often causes the investor to abandon their investment strategy, in some cases doing irreparable harm to their financial situation.  One measure of risk tolerance, then, is the investor’s emotional capacity to accept market volatility and their subsequent response to it. 

An equally important, but often less considered measure of risk tolerance is an investor’s financial capacity for a loss of capital.  Financial risk capacity is determined to be the amount of loss a person can sustain before compromising his or her ability to achieve their financial goals and objectives.  Financial capacity can often only be determined through the completion of a comprehensive financial plan or analysis.  

In some cases, one’s emotional capacity may exceed their financial capacity for loss.  Even though the investor may truly be able to hold through a significant market decline, their individual circumstances, and the timing of the decline – and any recovery from it – may put financial goals in jeopardy.  Like a scale, risk needs to be balanced between the fear response and the need for returns to achieve the investment goals.  Understanding the relationship between emotional and financial risk influences how aggressively or conservatively a portfolio might be invested.  

The use of a financial plan and IPS is considered best practice.  Developing a solid financial plan and IPS is not a typical exercise for most investors.  It requires a significant understanding of one’s goals and tolerance for risk, and provides support for following a well-conceived, long-term investment plan – especially during turbulent or exuberant times; a plan which, as the Cat said, “depends a good deal on where you want to get to.”