One area in the field of finance that is finding increasing acceptance is that of behavioural economics, or behavioural finance. Essentially, it deals with the various mental accounting errors that many of us can’t seem to avoid, and explores concepts such as overconfidence, negative-loss aversion and hindsight bias.

It seems most of us know the things we’re supposed to do when it comes to managing a portfolio, we’re just lousy at actually doing these things. For example, “buy low, sell high” is a maxim that many people ignore all too often, usually at their peril.

Institutional money managers have long used a strategic document known as an investment policy statement (IPS) to better manage clients’ expectations and curtail potentially self-destructive habits. Slowly but surely, IPSs have been making their way into the world of retail investments, too.

Think of an IPS as a “portfolio blueprint” that lays out the most salient elements of your portfolio’s design and management. These include: expected rate of return, tolerance for risk, time horizon, frequency of rebalancing, portfolio objectives and, perhaps most importantly, strategic asset allocation. A number of studies have shown that asset allocation explains the lion’s share of difference between how a balanced portfolio performs relative to its investment policy.

Contrary to what some may believe, you don’t have to use either a wrap account (which charges an annual management fee based on the value of invested assets) or a separately managed account to have an IPS. Any reputable adviser can draw up an IPS as long as it based on a consistent process of discovery, such as having the investor complete a detailed questionnaire.

Once the client has provided all the necessary information, it should be a snap to write a functional IPS. Most are three to five pages long (although they can cover considerably more ground for institutional clients). Some are text-heavy while others use bullet points, charts, graphs and spreadsheets. The important thing is that salient objectives are defined and agreed upon with the client. With an IPS as a guideline, a variety of products — such as individual securities, mutual funds, exchange traded funds — can be used to fit the asset classes chosen.

A simple example of how an IPS works would be to have one that calls for a 20-per-cent allocation in Canadian equity, and to then see the market drop such that Canadian equity makes up only 15 per cent of the portfolio. If an RRSP contribution were being made, it would then make sense to buy more Canadian equities to stick to the IPS plan. (You can also draw up an IPS on your own, and hold yourself accountable for buy/sell and rebalancing decisions. In years of experience in the financial services industry, however, I have only met one do-it-yourself investor who claimed to have implemented a functional IPS.)

An IPS is essentially a “mutual accountability” document, protecting both the adviser and the client from possible problems down the road. Because the main elements of the portfolio’s design and management are in writing, it would be difficult for either party to deviate from the agreed approach. Of course, an IPS isn’t written in stone; it should be revised if your circumstances change.

A major factor in the role of any financial adviser is to keep clients focused on the big picture, and an IPS can help keep things on track by reinforcing the “total portfolio” approach. Although we all know it’s prudent to buy low and sell high, many people balk when it comes to sticking with, or adding to, a product that has performed poorly when other parts of the portfolio are doing better. An IPS implicitly acknowledges that it’s improbable that all components in your portfolio will do well at the same time.

Financial advisers have been likened to personal trainers because they encourage you to do what you want to do and ought to do, but might not always do if left to your own devices. Think of an IPS, then, as a kind of workout regimen designed specifically to meet your needs, abilities and goals. With an IPS in hand, you’ll be better able to see and measure the results of your financial fitness plan.

John De Goey is a senior financial adviser with Burgeonvest Securities Ltd. in Toronto. The views expressed are not necessarily shared by BSL.