Broadly speaking, an investment policy statement (IPS) is a document that defines how an investment portfolio is managed. Investment policy statements have long been used by investors that manage large portfolios. Managers that oversee pension funds, endowments and investment assets owned by life insurance companies adhere to investment policy statements in an effort to increase the likelihood that the investment goals established for the particular account will be met.
But individual investors are increasingly turning to IPSs when setting up their portfolios. Having a plan in place also aids in the decision-making process by reducing the chance that emotionally laden judgment calls will drive investment decisions. Read on to learn how to set up an IPS and how it can help you achieve your investing goals.
Investment Policy Statement for the Average Investor
While investment policy statements have been commonly used by institutional investors and those that oversee large portfolios, they have not been as commonly used by investors who manage smaller accounts (i.e., individuals that have taxable brokerage or retirement accounts). Investors that manage smaller accounts have been inclined to take a wait-and-see approach. That is, many have elected to invest at regular intervals and hope that the accounts will accumulate in value at a rate that will satisfy future requirements.
For instance, take investors who manage their own individual retirement accounts. These investors often do not create investment policy statements. Instead, they deposit regular contributions into their accounts and hope that one day they will have enough money to retire. This turns out to be an effective strategy for some. Unfortunately, others find that they must delay retirement because they have not accumulated enough wealth (To learn more about retirement accounts, please see IRA Contributions: Eligibility & Deadlines and Supplementing Your Retirement Income With IRAs.)
The prospect of delaying retirement has not served to be a strong motivator for most small investors to create an IPS. However, recently, it appears that more have begun to catch on to the idea that having an IPS in place is important. This recent shift in thinking may be due to the wave of investors that will soon leave the workforce and enter into retirement. The worry that people will outlive their assets has motivated an increasing number of small investors to look into creating an IPS to guide the process by which they manage their portfolios.
Essential Sections in an Investment Policy Statement
A simple IPS can be created with as few as six sections. The six sections core to an investor-created IPS are:
- Account information
- Investment objective
- Risk tolerance
- Allowable assets
- Rebalancing guidelines
- Unique circumstances
Account information reveals the actual accounts that will be managed according to the IPS. For instance, an investor may elect to manage a qualified retirement plan, taxable account and a trust based on the same IPS.
The investment objective is self explanatory. This section of the investment policy statement identifies the investor's investment objective. Investors who seek to generate high returns may use a term such as "growth" here. Investors who only desire to produce income in the portfolio may describe their investment objective as "current income".
Risk tolerance is another section that is fairly straightforward. Risk tolerance indicates the amount of volatility that the investor is comfortable with having in the portfolio. Risk tolerance questionnaires available on the internet or from a financial services company may aid investors in determining their individual risk tolerances. (For more insight, read Personalizing Risk Tolerance and Determining Risk And The Risk Pyramid.)
This section of the IPS indicates the assets that the investor will allow to direct investments. Risk and return, by convention, are factors that may cause investors to choose one asset over the next. For example, an investor with low risk tolerance that is near retirement would be more likely to choose safe, but lower yield assets like Treasury bonds. Liquidity, marketability and withdrawal fees could be additional factors that are used to determine an investor's allowable assets. Items such as domestic equity, international equity, private equity and real estate may be included here.
Rebalancing guidelines reveal the conditions under which the investor will rebalance the portfolio. Investors may choose to rebalance the portfolio quarterly, semi-annually or annually. Other investors believe that a better approach to take is to rebalance when target ranges have been violated. For instance, an IPS may indicate that 75% of a portfolio should be invested in domestic equity. However, the portfolio is allowed to hold as little as 70% domestic equity and as much as 80%. Thus, the portfolio would be rebalanced any time the domestic equity is outside of the 70-80% window. Individual investors can also use this opportunity to evaluate portfolio performance. One method of doing so is to compare the absolute return generated to his individual needs. For example, if the portfolio generated 6% during the calendar year but the investor's needs call for 8%, then the portfolio has underperformed by 2%. (For more on rebalancing, read A Guide To Portfolio Construction.)
Finally, it is essential for all investor-created IPSs to contain a unique circumstances section. This section would detail any investor specific information. For example, charitable giving or ownership of closely held stock may be indicated in this section.
There are a host of additional sections that could also be included in an IPS. Sections titled "frequency of portfolio reviews", "tax considerations" and "constraints" are only a few examples of additional sections that could be added. Finally, some investors may find a "constraints" section beneficial as well.
Creating an Investment Policy Statement
Investors can create an investment policy statement by taking a moment to think about the reasons why they maintain investment accounts. From there, it is a matter of filling in the information for the aforementioned essential sections. Investment objective, risk tolerance and the other items can be established after some thought has been put into the reason why the accounts exist. While some investors will have to conduct research into different asset classes in order to establish a list of allowable assets, this information is readily available on investment-related internet sites. Another alternative would be to seek the assistance of a trusted advisor.
IPSs should be updated when investor circumstances change. For instance, a life-changing event such as marriage, divorce, the birth or death of a family member, or winning the lottery could warrant the need to change the IPS.
Growing in Importance
Investors that manage smaller portfolios are beginning to buy into the importance of having an investment policy statement. Having an IPS in place that clearly outlines how investment assets will be managed and monitored may help even individuals with modest accounts attain their investment goals.