Do you have a written investment policy statement (IPS)? No? Why not?
I'm not trying to be flippant here. This is one of the most important financial questions I ask of new high-net-worth clients. And I admit, I catch some of them off-guard. Almost every one of them can articulate a rough idea of their investment goals and risk tolerance. But not all of them have taken the time to do so in a measured, written way.
Over the years, I've heard a lot of different "reasons" for not having an IPS: "I never got around to it." "My portfolio has been doing fine without one." Or my personal favourite: "My IPS is in my head." At their core, all of these excuses demonstrate a misunderstanding of what we really do when we invest.
To many, the purpose of investing is simple: make money. And I understand that, as far as it goes – that's my purpose too. However, I believe it's a very "surface" way of thinking about the investment process.
In reality, the reasons we have for making money are much deeper and much more personal. They reflect highly individual goals and family objectives, and a unique vision of what we want for the future.
And that's why you need an IPS. It forces you to explain and define the "why" behind your investment moves. It encourages you to provide concrete definitions to your goals and objectives.
And by doing so, it helps you forge a critical quality shared by nearly every successful investor I've ever met: discipline.
I think of an IPS as a kind of personal investment plan. It establishes a degree of professionalism to the process of managing your money, while minimizing irrationality or "off-the-cuff thinking" when it comes to investment decisions.
By putting your financial purpose in writing, you'll be better able to focus on your goals, instead of the crisis du jour.
Can you be a successful investor without writing an IPS? I suppose so – for a time, at least. But it's no coincidence that nearly every successful high-net-worth investor (including Warren Buffett) I've ever met ends up writing an IPS, eventually. If you don't have one, you are doing yourself and your family a disservice, and giving emotions an opportunity to overrule a rational decision-making process.
With that in mind, allow me to provide an overview of the four topics we cover in the IPS documents we use in our practice. While this isn't a complete picture of an IPS, it should give you a good idea of how you can start writing your own.
Investment objectives
This is usually the first part of an IPS, and to my mind, the most important. Beyond "make money," what exactly are you investing for? What is the purpose of your money? What (and who) is this portfolio supposed to provide for?
This section also details your investment time horizon, your liquidity, tax treatment preferences and income requirements and your target return objectives. Most important of all, you'll detail your aggregate risk tolerance, defined as an acceptable percentage of downside in an annual time period, or from peak to low (maximum drawdown).
Portfolio allocation
In this part of the IPS, you'll sketch in the details of where you want your money to go, both in terms of return and in terms of risk. You'll define your investment philosophy in broad terms (such as growth/balanced/value/uncorrelated) and state your over-arching investment strategy (active, passive, or a mix of the two).
You'll establish the percentage of your portfolio that you'll invest in broad asset classes, along with detailing the level of risk (or standard deviation) you can expect for each of those asset classes. It also establishes benchmarks that will be used to evaluate ongoing performance.
In our practice, we typically break all this down in a chart that includes detailed percentages of certain assets – cash, fixed income, public and private equity, alternatives, real estate, along with any operating business assets a client may have. Frequently, we include a current allocation and an "in five years" strategic target allocation, so we can determine a framework for what changes we're looking to incorporate over the next several years.
An important part of the allocation section is to detail permissible (and impermissible) investments. Your goal here will be to detail any investment restrictions(such as credit quality, corporate social responsibility exclusions – no tobacco, no defence stocks), and also mitigate "risk drift": the propensity to add risk during comfortable markets (tops), and to reduce risk during panics (bottoms). In times of extremes, your IPS can act as an impartial reference guide, keeping you on the right path to reach your long-term objectives, regardless of market vagaries.
Roles and responsibilities
At its core, your IPS is also a relationship-building document: One of its main goals is to clarify the relationship you have with your money, and the relationship you'll have with the professionals who manage your money with you.
So in this section, you'll write down who's responsible for doing what, and define exactly how "hands on" you want to be with your portfolio. Generally, you'll break this down into two sections: (a) what the client family is responsible for, and (b) what the professionals are responsible for.
You can allocate these responsibilities in whichever way you like. But setting it down in writing is a good way to establish expectations, and evaluate how your professionals are meeting those expectations.
Rebalancing/resetting rules
In this section, you'll provide some general parameters for rebalancing or resetting your portfolio, or your "tactical" allocation rules. It will establish your dividend policy (whether you reinvest them, or take them as cash).
Sometimes this section will be quite detailed. Other times, it's very general, simply delegating rebalancing responsibilities to the professionals who manage the portfolio.
I'll close by pointing out for this upcoming year, I think the value of an IPS is even more pronounced. Already, 2015 has proven to be a challenging year. Several economic and political events have the potential to cause ongoing disruption over the next several months. In such an environment, an IPS can be a tremendous help in keeping you anchored when volatility picks up.
Thane Stenner is founder of StennerZohny Investment Partners+ within Richardson GMP Ltd., as well as director, Wealth Management. Thane is also chairman emeritus of TIGER 21 Canada. He is the bestselling author of True Wealth: an expert guide for high-net-worth individuals (and their advisors). (mailto:thane.stenner@richardsongmp.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates.