As an individual investor, do you need an investment policy statement (IPS)? If so, how does one go about constructing such a thing? This post will examine these questions and go into some detail about investment policy statements as a useful tool in your personal portfolio management.

The IPS is a well known concept in the world of institutional investing. Most large institutions from pension plans to endowments and insurance funds are required either by law or by their own charters to have one. Although these documents can be long and complicated there is no reason why they have to be, and in my opinion the best policy statements are the ones that say what they need to say in the shortest amount of space necessary. I think you can help your investment prospects by knowing how investment policy statements are structured and how they can be applied to your own situation.

An investment policy statement consists of three essential parts: return objectives, risk tolerance and special circumstances. These are all interrelated, but deserve to be addressed and formulated separately.

Return Objectives

Perhaps surprisingly, many investors fail to actually translate their return objectives in to an actual defined statement. “I want to make tons of money as soon as possible” is not a return objective. “I want to generate returns at least in excess of annual inflation by 1-2% with an orientation towards growth (capital appreciation) over income” is a reasonable return objective. Investors find that it can be incredibly helpful to simply take a bunch of general ideas and boil them down into a statement. A return objective should be concise, realistic (i.e. not “doubling my money every year”) and descriptive (for example specifying a preference for asset appreciation over income, or vice versa).

Risk Tolerance

Every investor has to sit down at some point and think about how much risk he or she feels comfortable taking in pursuit of targeted return objectives. It may help, for example, to look at the “risk considerations” section of Jemstep’s investor profile for ranking assets, which prompts you with a variety of questions about your relationship to risk in making investment decisions.

Risk tolerance can be broken down into two things: risk capacity and risk propensity. “Capacity” has to do with your financial circumstances – how much net worth you possess, what your income needs are to preserve your lifestyle requirements, and what percentage of your total income needs are represented by the portfolio (for example). “Propensity” relates to your willingness to contemplate the possibility of very large losses in the short term in pursuit of higher longer term returns.

Special Circumstances

The third section of the policy statement is where you map out all the things that loom large in your financial plans. For example “time horizon” is a special circumstance – what are the major events such as college education, starting a business, buying a vacation home or retiring that are in your line of sight looking ahead? Related to time horizon is the circumstance of “liquidity needs” – based on these future events, how will your required income stream vary up or down? Finally, issues such as tax and legal considerations (for example national or municipal residence status, philanthropic designations and so forth) can be considered special circumstances.

Going through this exercise of setting out your investment aspirations in a policy format can provide increased clarity about the right decisions to make for your portfolio. Armed with a grounded set of statements about your return objectives, risk tolerance and special circumstances, you can compare the risk / return properties of different investments (equities, fixed income and so forth) and allocate weights to different instruments in line with the policy. It is a good discipline, and one that can lead to increased success in investing over the long term.

TAGS: portfolio management