Personal Investment Policy Statements

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It is standard practice for professional fund managers to prepare an Investment Policy Statement (IPS) to guide investment decisions and to force them to be clear about exactly what the investment objectives are, how they are going to be met and how the investments are to be managed.  For similar reasons, self managed superannuation funds are required by law to develop and implement an investment strategy, which is usually accomplished by the writing of an IPS.

Given the usefulness of an IPS in helping to clarify the investment aims and methods for institutions and superannuation funds, it is surprising that their use is not more frequently encouraged by advisers for individuals for their ordinary investment portfolios. A good IPS provides an anchor for an investment plan and guidance for specific asset allocation strategies and portfolio construction. Planners who do prepare them for their clients find them useful when establishing investment goals, documenting risk profiles, choosing suitable investments, reviewing investment performance and defending decisions in the event of legal challenge. They form a logical component of a comprehensive Statement of Advice.

A good investment policy will be customised to each individual’s needs, along with the rest of a financial plan. Nevertheless, there are common components, including time horizon, goals, investment risk and reward profile, liquidity and cash-flow requirements, rebalancing guidelines, preferred asset classes (and assets to be avoided) and a control framework that will guide the strategies in all market conditions.

Off-the-shelf policies are available, but if clients are to treat their IPS as the backbone of their approach to their investments, they will need to be involved in its preparation and fully convinced of its relevance to their circumstances.

Insights from behavioural finance indicate that investors have many irrational biases. Some are a tendency to hold bad investments too long, overconfidence, a readiness to follow the herd, allowing sunk costs to influence present decisions and beliefs that losses aren’t real until an asset is sold. Not many ideas are as damaging to the implementation of a disciplined approach to investment as this idea of the “paper” loss.

The antidote to these irrational impulses is to lay down the ground rules before decisions are required, and then to apply them rigorously when those decisions should be taken; in other words, to prepare an IPS containing detailed investment guidelines and then to follow them.

Components of an IPS

A fund manager’s IPS is effectively an agreement between the investor and the institution. For individuals managing their own assets, it still has the feeling of an agreement with oneself about how investment decisions will be dealt with. A common temptation with all IPSs is to write them in terms that are too general. The detail should be quantified. The main matters that will be addressed will be these.

  • Time horizon
  • Investment objectives
  • Investment risk and reward profile
  • Liquidity and cash-flow requirements
  • Rebalancing guidelines
  • Preferred and allowable assets
  • Monitoring and control
  • Special considerations

Time horizon

Time horizons are frequently underestimated. We still see SoAs containing superannuation advice that puts the planned retirement date as the time horizon, despite the fact that the investments may be required for 30 years or more beyond that date. For clients who do not intend spending down their entire capital in their own lifetimes, the time horizon will extend to a new generation.

That realisation can avoid asset allocation mistakes and a reminder of time horizons in an IPS can help clients to resist the temptation to panic in downturns, or to overspend during long bull markets.

Investment Objectives

Few would disagree with the idea that investment objectives or goals are a crucial part of an investment strategy, but a common failure is to document goals that are either too loosely defined or simply not realistic. Expressions such as ”maximise returns” and “minimise risk” are so broad that they become meaningless as a guide for actual “real-world” decision making. More specific, measurable goals would be to generate an income stream of 4% pa after tax, with growth over any year to equal the performance of an indexed growth fund (one should be nominated) and over a business cycle to equal the growth in average weekly earnings. Some clients may choose the goal of keeping pace with the growth in consumer prices, rather than maintaining their relative position with wage earners. The preparation of an IPS gives an adviser the opportunity to have the discussion, and for the investor to decide.

Investment Risk and Reward Profiles

Every adviser will have a risk profiling procedure that is carried out with clients before recommendations are made. But these tools are frequently targeted almost exclusively at tolerance for investment risk and the ability to withstand investment volatility. Also, there is often a very tenuous link between the profile of the investor and the profile of the investments. An earlier article in this magazine pointed to the equity like risks that can be experienced in some fixed interest like investments, and the breaking down over the last few years of simplistic assumptions about diversification and volatility. Finally, the crucial inflation and longevity risks must be addressed. An IPS should list all the common risks that face investors and outline the specific strategies that will be used to deal with them.

Liquidity and Cash-flow

Financial plans will invariably include detailed cash-flow forecasts, and the investment plan must take account of liquidity needs. The IPS will consequently include the plans for significant additions to and withdrawals from the portfolio, and take account of these in describing the asset allocations and the selection of individual investments.

Rebalancing guidelines

Rebalancing guidelines specify when the investor will rebalance the portfolio. This can be at specific time intervals (quarterly, semi-annually, annually) or when target ranges have been violated. The rule might be, for example, to re-balance if the Australian equity component falls outside the range of 40% to 55% of the portfolio value. Of course rules like this need to be backed up by appropriate administration. How is the client to keep track of the asset allocation, which varies constantly?

A review of the asset allocation might also be required by the IPS if performance varies dramatically from plan. For example, if real interest rates increase strongly, then a re-weighting towards equities might assist growth objectives while maintaining income goals.

Preferred and allowable assets

Some assets may be out of the question for ethical or religious reasons; others because of the risk profile or simple dislike by the investor. Rules might be set about the use of derivatives, for example, from an outright prohibition to the use of covered positions only.

Private equity and family support  are other matters to include. It is better to consider whether or not investment funds can be used to support the entrepreneurial activities or personal needs of family members, and if so to what extent,   well before a request is made, when the emotional component may be high and bad decisions made.

Monitoring and control

Investors typically review their investments too frequently, and consequently over-trade. On the other hand, if rules are in place in the IPS regarding re-balancing or “stop loss” points at which particular assets or asset classes will be sold down or acquired, then monitoring will be required. Some, such as “stop-loss”, might be automated through broker software, some might be out-sourced to an adviser such as a financial planner, and some might need information to be assembled and examined by the investor. Preparation of an IPS will force consideration of these options, decisions to be made and the implementation of those decisions in a workable schedule of review and monitoring activities.

Special considerations

An IPS should also cover any unique or unusual aspects applying to the investor. Perhaps some parts of the fund need to be quarantined in a special account for a family member with particular needs for financial support. This component may have a feel of “trust”, even if a formal trust fund is not established. There may be delegations of authority to deal with assets which are described here; for example, a student may be given emergency access to a CMT which should only be used under circumstances described. An objective might be to support charities, in which case a policy can be described. How much is to be given, and when? Under what circumstances would donations cease or be subject to review?

Summary

An IPS is a very useful document for any investor to have at hand. In the preparation, it will be useful in forcing decisions concerning the many issues that should be considered. In operation, it will drive a much more disciplined approach to investment management than would otherwise be the case.
It should be concise, (perhaps 3 to 5 pages) written in plain English and contain a minimum of generalisations and a maximum of specific guidelines concerning the management of the investment portfolio.
 

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