As discussed in “A Quick Look Back”, we have reviewed many key investment related concepts over the last two years.
Investment risk, expected returns, diversification, asset correlations, risk, return, active versus passive management, and information on the core asset classes.
And much more.
Understanding the core concepts underlying the investment process will help the next steps make sense.
In 2019, we will move to the creation and management of investment portfolios.
The Next Step in the Journey
The next step in developing an efficient and effective investment portfolio is creating an Investment Policy Statement.
Okay, maybe not for most people. This is an investment mechanism that is often ignored.
But it is something that is important for successful investing and should be utilized.
What is an Investment Policy Statement?
You may also see it referred to as an Investment Plan, Investing Strategy, or by other names. And you may see Investment Policy Statement refer to the agreement between a financial advisor and client as to how the client’s assets will be managed. Be aware that the title and content may slightly differ depending on context.
In my world, I will go with the following name and content.
An Investment Policy Statement (IPS) is a written document that defines an individual’s planned investment strategy.
The IPS provides an outline as to how the portfolio should be constructed and managed.
The IPS also serves as an evaluation tool and report card on the performance of the investment portfolio.
Comprehensive Investor Profile
It starts with information concerning the investor’s unique profile.
What type of investor is the individual behind the IPS? What is the investor’s current financial position? What are that person’s investment objectives? Are there any constraints that may impact achieving the stated goals?
Are there any specific investments or asset classes expressly to be included, excluded, or monitored?
The individual’s risk tolerance, investment time horizon, legal situation, ethical concerns, and phase of the life-cycle, are important considerations within the investor profile.
Asset Mix
The investor profile determines the appropriate asset classes for the investment portfolio.
It is also used to develop the optimal target asset allocation in creating a diversified portfolio.
Based on studies, many finance professionals believe that asset allocation explains approximately 90% of the variability of returns in a portfolio. As a result, asset mix is more important than individual security selection in creating effective portfolios.
This is a key segment in the IPS to get correct.
Portfolio Construction and Management
The IPS will define portfolio construction and subsequent management.
Depending on who is managing the portfolio, the IPS may include: creation of investment accounts; funding of the account; use of power of attorneys; asset classes and investment styles employed; process of buying and selling securities; and other related matters.
Should a third party be managing the account, this is a crucial section to agree upon. Otherwise, misunderstandings (or worse) can destroy the business relationship and jeopardize the investment portfolio.
Performance Benchmarks
The IPS should include the agreement of pre-determined benchmarks that will be used to assess portfolio performance.
Benchmarks should directly relate to the target asset allocation and type of investments that will be made.
Review and Remedial Measures
Finally, the IPS should state the process and periodicity for monitoring the portfolio. As well, how to address any deficiencies or adjustments in the portfolio after review.
Importance of a Written IPS
The IPS should be a written document.
It provides a clear and detailed blueprint to follow and a means to evaluate performance.
Maintains Focus
By having it formally documented, it will help keep you focussed on your plan. It will promote a consistent and disciplined investment approach that you require to succeed.
It will also provide support and keep you on the right path during turbulent market times, which occur often.
A formal IPS is important for you in managing your own money. It is even more important when relying on someone else to manage your portfolio.
You must be on the same page as any advisor you utilize. The advisor must completely understand your unique situation and implement the plan exactly as envisioned.
Provides Protection
A written document that has been signed off by both parties provides protection.
It protects the investor against unwarranted moves made by the advisor.
It can also protect the advisor against unhappy investors who may claim negligence where there is none.
Living and Adapting IPS
As you can easily see, your personal investor profile drives the target asset allocation. Which, in turn, drives individual investments, benchmarks, and remedial actions.
The IPS is not a static document. As your life continually evolves and the world changes, your unique investor profile will shift. And your IPS will require adaptation.
Okay, a nice summary of an IPS. We will examine the components in greater detail over the next few weeks.
