The Investment Policy Statement

The Investment Policy Statement (IPS)

An investment policy statement is an invaluable planning tool that adds discipline to the investment process.

Before developing an IPS, an investment manager must conduct a fact finding discussion with the client to learn about the client's risk tolerance and other specific circumstances.

The IPS can be thought of as a roadmap which serves the following purposes:

• It helps the investor decide on realistic investment goals after learning about financial markets and associated risks.
• It creates a standard according to which the portfolio manager's performance can be judged.
• It guides the actions of portfolio managers, who should refer to it from time to time to assess the suitability of particular investments for their clients.

Major components of an IPS

• An introduction that describes the client.
• A statement of purpose.
• A statement of duties and responsibilities, which describes the duties and responsibilities of the client, the custodian of the client's assets, and the investment manger.
• Procedures that outline the steps required to keep the IPS updated and steps required to respond to various contingencies.
• The client's investment objectives.
• The client's investment constraints.
• Investment guidelines regarding how the policy should be executed (e.g., whether use of leverage and derivatives is permitted) and specific types of assets that must be excluded.
• Evaluation and review guidelines on obtaining feedback on investment results.
• Appendices that describe the strategic asset allocation and the rebalancing policy.

****The Investment Policy Statement

The purpose of the IPS is to put in writing exactly what you're trying to accomplish with your portfolio, how you plan to get the job done, and how you'll measure your progress along the way.  It should serve as the anchor that keeps you from drifting away from your plan to chase the latest hot tip or investment fad.  By helping you to stay focused on your long-term goals, it can also keep you from becoming so discouraged by the inevitable setbacks that you give up on investing altogether.  An IPS doesn't have to be a complex document, but it should include the following: 

• Your risk tolerance
• Your time horizon
• Your need for current income
• Your need for long-term growth
• Your plan of action
• Your schedule for measuring your progress

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Your risk tolerance

A great way to measure your risk tolerance is to decide what percentage you're prepared to lose in any given year without abandoning your strategy.  Be honest with yourself.

Translate the percentage numbers into real dollar amounts.  It's one thing to tell yourself you can sit calmly through a 20 percent decline, and another to open an account statement that shows one out of every five dollars of your hard earned money seems to have disappeared.  Since the markets tend to spend about a quarter of the time falling, sometime during your lifetime as an investor it's virtually certain that you'll be facing losses in your account.

Big return targets, whether for growth or current income, tend to increase the likelihood of big dips in portfolio value.  Investors are infamous for selling at market lows in a panic, usually just before the market recovers.  The more harrowing the ride, the more likely you are to want to get off.  Be sure you don't put yourself on the path to surrender by choosing too dangerous a route.  If you're not prepared to accept any declines along the way, then you're not entitled to the superior gains that stocks have traditionally provided.  That's fine; just scale back your plans to match the steady but lower long-term returns you'll probably be able to get from fixed investments.

Your time horizon

Your time horizon is simply how long you plan to maintain your current investment strategy.  It's usually tied to some major expense or event, such as the arrival of college years for the kids or a planned retirement date.  For investors already in retirement, the time horizon for an income portfolio may be their life expectancy.  The shorter your time horizon, the more conservative your plan should be.  As we have just witnessed, markets can go down for several years in a row.  While they have always eventually recovered in the past, the markets may not follow your timetable, leaving you short of the necessary funds when it's time to write the check.  In general, money you absolutely need to spend within four or five years should not be a part of your investment portfolio.

Your need for current income

Your need for long-term growth


The total return your portfolio provides is made up of two parts:

• income and
• growth. 

If your portfolio is providing you with the cash you currently need to support your lifestyle, you need income.  We believe there are potential pitfalls in relying on the systematic liquidation of portfolio growth ("dollar lost averaging") to fund your current income needs and that these pitfalls are serious enough to offer a strong argument for basing your withdrawals on the cash income your investments can generate instead.

 

How much money do you need to take from your portfolio today?  How much will you need in the years ahead as the cost of living rises?  Is your portfolio big enough to produce that much cash?  An investor with an $800,000 portfolio can get $1,000 per month by taking cash at just a 1.5% annual rate, while someone with $150,000 invested needs to draw cash at an 8% rate to pocket $1,000 per month.  If prevailing rates are around 4% and you need to take 12% to make ends meet, you've got trouble.  Your choices are to cut your expenses or shop at the high yield end of the investment market where risks are greater.  As the spread between what's reasonable and what's necessary grows, so does the likelihood of depleting a portfolio.

Those investors who don't need to take current income from their investments, or who have more than enough invested to meet their needs, can focus on growing their portfolios.  You'll still need to know your required rate of return - the total return you'll need to achieve, on average, to take you from where you are right now to where you want to be.  Answering the following questions will help you to find your required rate of return. 

• How much will your future goals cost once inflation is taken into account?
• How much have you accumulated so far?
• Where is the rest going to come from in the time you have remaining?
• Is there a rate of return you can reasonably expect that will help you get the job done, and can you actually achieve that return while staying within your comfort level?

Without the pressure of monthly withdrawals, investment income can be reinvested to provide for future income goals, inflation protection, or generational wealth creation.  As part of your total return equation, the level of income you should be looking for can be matched to the distance in dollars you have to go to reach your goals, and risk you're prepared to assume to get there.

Your plan of action

The description of your plan of action can be as simple as "Invest primarily in dividend-paying stocks," or as comprehensive as a complete summary of the details of your investment process.  The key is to create a benchmark against which you can measure every investment decision you make to help you keep your plan on track. 

Your schedule for measuring your progress

Plan on reviewing your progress at predetermined intervals spaced at least one year apart.  This is not the same as the process of regularly monitoring your securities.  It's a chance to take a fresh look at your circumstances to see if there have been any material changes in your income needs, time horizon, or risk tolerance.  The purpose of this review is to make sure your plan of action still makes sense given any changes in your situation, and to help you keep your overall investment experience tied to the long-term context of what you hope to achieve.  This review is about you, not about the markets.  The investment environment is always changing, and your plan of action already takes that kind of change into account.  Be careful not to let what's going on right now in the investment markets alter your strategy.

Keep a historical perspective in mind.  Big bull market advances don't last forever, and neither do major bear market declines.  So long as your process is performing as you would expect under the circumstances and still meets your needs, your Investment Policy Statement should not require a major revision.

Set clear investment policy statement

NST Online » Focus
2008/09/07

Business: Set clear investment policy statement
By : Yap Ming Hui


The great Greek philosopher and mathematician Plato said: “The beginning is the most important part of the work.”

After you have developed a financial plan, you are ready to start investing for your financial goals — almost, but not quite. It is time to have an investment policy statement where you set parameters within which the portfolio is to be managed over time.

Why have an investment policy statement

The principal reason for an investment policy statement is to protect your investment portfolio from ad-hoc revisions of sound long-term policy.

The investment policy statement is used to keep our selves from taking those unwise actions that seem so “obvious” and urgent to optimists at market highs and to pessimists at market lows.

As human beings, we like best those upward market movements that are most adverse to our long-term interests, and most dislike those downward market movements that are, in fact, in our long-term interests

As such, investors need protection from their human proclivities toward unrealistic hopes and unnecessary fears. Therefore, the best shield against the outrageous attacks of acute short-term data and distress are knowledge and understanding — committed in writing.

We can think of an investment policy statement as a letter of understanding between the investor and the investment manager.

In the absence of professional investment manager, it is a letter of understanding between you and your own self to protect the investment portfolio. The problem, as Santayana so aptly put it, is that “those who cannot remember the past are condemned to repeat it.”

The benefits of investment policy statement

The benefits of a proper investment policy statement are as follows:

- It provides a written description of the investment decision-making process from objective setting through implementation and ongoing monitoring of progress toward the goal

- Is a model against which to measure performance

- Provides a framework for evaluating new investment opportunities as they come along

- In the case of using a professional investment manager, an investment policy statement can provide for continuity in investment approach as new investment manager replaces those who are stepping down

- Serves as the non-emotional tether that you can use to ground yourself when markets are misbehaving and the temptation to act impulsively or irrationally is high. This is particularly important during extremely good or bad stock market environments

- Can be made part of the financial or estate plan. This could be particularly important for older investors who have build sizeable portfolios. When the investor dies, the estate executors or administrator won’t have to second-guess the intended investment strategy of the portfolio. It can be left intact for the heirs for many years if that was the deceased’s wish. This might be desirable when the heirs are minors or have spendthrift habits.

Content of an investment policy statement

A complete investment policy statement must be able to establish useful guidelines for investing that are appropriate to the realities of your objectives and the realities of the investments and markets. As such, there are two main components of an investment policy statement. First is your objectives and tolerance of risk. Second is the external realm of investment market.

In short, investment policy statement is the linkage between your long-term investment objectives and the daily/ weekly investing home works.

A proper and complete investment policy statement is set out as follows:

• Background and purpose.

- Why the investment policy statement was written — by whom, for whom and when.

- Who has the responsibility for what

• Objectives

- Projected financial needs — how much and when

- Present asset allocation — where are you today?

- Risk tolerance and time horizon of the investor

- Risk profile and investment time of the portfolio

• Investment policy

- The “rules” by which the investment strategy will be implemented

- Acknowledgement of the uncertainties of investing

- Investor preferences for asset classes or securities

- Desired rate of return

- When and how to re-balance

• Security selection

- Criteria for choosing securities

- List of types of securities not to be included in portfolio (eg, tobacco, alcohol, gambling)

- List of types of transactions not permitted (eg, leverage, options, commodities)

• Duties and responsibilities (if engaging professionals)

- The investment manager

- The custodian

• Manager selection (if engaging a professional investment manager)

- Results — cumulative and year-by-year

- Risk — volatility

- Rank — peer group performance

- Resources — Who is running the show? Services?

• Control procedures — monitoring

- Monthly — current holdings, market value and transactions

- Quarterly — How is the portfolio doing against the benchmark? How is the manager doing against his or her peers? Is the asset allocation being followed?

- Annually — Review investor’s risk tolerance, desired rate of return, asset class performance and time horizon to major financial needs. Analyse expenses and fees paid.

• Appendix

- Modeled return, standard deviation and correlation statistics for the asset classes used to diversify the portfolio

The test of a good investment policy statement

A well-written investment policy statement should be able to let anyone reviewing the investment portfolio to follow what was done. Guidelines should be specific enough to make it clear what was intended, yet give whoever is charged with implementing the strategy authority to actively (but prudently) manage the portfolio.

The litmus test for a well-written investment policy statement is whether there is sufficient detail and clarity for the investment portfolio to be implement by an investment manager who is unfamiliar with you (whether professional is engaged or not).


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Yap Ming Hui is the managing director of Whitman Independent Advisors Sdn Bhd, the first multi-client family office in Malaysia

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