It has always been a standard practice to have a robust investment policy statement (IPS) for institutional investors, but what's interesting is that this practice has become more common among individual investors. In fact, it has become a requirement for investment firms to have this statement drafted and agreed upon by the investment manager and his or her clients. This is also one of the first documents the Securities and Exchange Commission (SEC) will sample during an audit. This is not a bad thing: A good policy not only keeps the overall investment plan well grounded, but it also provides a road map to develop specific asset allocation strategies and detailed investment guidelines. Here we take a look at this document, and show you some of the common pitfalls investors fall into.
Do It Yourself
There are some basic must haves for any good investment policy, including specific details unique to each investor, investment time frames, investment goals and basic starting points for each asset class. It is also important to actually follow the policy and remember it is the backbone of your long-term plan.
While it's tempting to grab any off-the-shelf policy, there are some common pitfalls with this method that are avoidable if you know how to spot them. The importance of an investment policy tailored to your personal characteristics has become even more apparent during the multiple market gyrations over the last 10 years. In fact, the investment policy statement is now considered to be the main step in using a sound investment philosophy to set detailed investment guidelines. (For a brief history of money management, read The Evolution Of Money Management.)
Elements of a Good IPS
Typically, an investment policy statement is a formal agreement between the investor and the institution managing the assets on the investor's behalf. If you are managing your own assets, it still makes sense to develop a policy to keep your strategy in line. Whether the IPS is generated by the investment manager or the investor, one common pitfall is to gloss over many areas and not drill down to quantify the details. Considering how important the IPS is - it's actually required by law under ERISA and most RIA applications - it's clear that this step is not to be taken lightly. Here are the basic must haves for a good basic policy:
- Specific factual data unique to the investor (such as personal preferences)
- Time horizon
- Risk tolerance
- Rebalancing guidelines
- Asset classes to avoid
- The control framework that will guide the strategies in every market condition
Never Enough Time
Time horizon is one of the most misunderstood concepts when it comes to investing. Many investors assume their time horizons are much shorter than they actually are. This leads to the same asset allocation mistakes over and over again. Your time horizon is not the day you retire or even the day you pass away and leave your financial legacy for your beneficiaries. An investment time horizon can be much longer than most people think - it can even extend into the next generation if the investments are to be passed on. Ensure your time horizon is appropriately identified prior to the start of the investment process.
Eyes on the Prize
Investment goals are vital when developing an investment policy statement. A common mistake is to choose goals that are either too general or simply not realistic. Goals like "make money" or " get good returns" are just not relevant. Goals should be specific to your long-term philosophy, creating a natural stepping stone to your investment guidelines. For example, a goal may be a 10% return on risk capital with the plan of using that 10% return for an annual vacation. This goal sets a distinct target return and a potential use of those returns. This is a short-term goal that can fit in a longer term philosophy melding lifestyle and wealth goals. (For more information about the investment policy statement, check out Profit With Investment Policy Statements.)
Let's Talk About You
There should also be some specific language relating to the investor's unique characteristics, including liquidity needs, minimum yield requirements, fiduciary responsibility and specific delegation of authority. This type of information is unique to the investor, so it is impossible to use an off-the-shelf IPS. As the IPS becomes a legal requirement for various kinds of asset managers, there is the temptation to just fill in the blanks of a template, but the best method is to construct them from scratch.
The IPS is a written document signed off and agreed to by both the investor and investing company, so there is no excuse for not following it. For those who are relatively new to the IPS concept, it is quite common for the first run through on the IPS to be off slightly. In this case, the investor naturally tends to move away from the original version.
Since the IPS is an extension of the investor's philosophy and leads directly into his or her specific investment strategies, there is room to adjust. Just remember to make the adjustments early on to create a plan you can stick to as soon as possible. It is generally against the law for investment firms to stray from their previously agreed upon IPSs. Also, switching strategies too often will not only make it impossible to give your strategy a fair test, but it will also incur fees because you will have to alter your portfolio to match your strategy. However, it is always OK to take a step back, make adjustments and have both parties agree on the changes.
Use Plain English
Another common pitfall in the development of an IPS is to use language that is either too broad or too restrictive. Both are fatal errors that can create confusion and make it very difficult to follow the IPS. It is not necessary for an IPS to be a long, drawn out document with never-ending legal language. It helps both parties when the IPS is both easy to understand and interpret - that is, clear and consistent with the investor's well-defined goals.
Language that is too broad can lead to trouble down the road, especially during volatile market times when investors are tempted to make short-term decisions not clearly defined by their IPSs. It is also important not to overwrite the IPS – something investment managers may do to cover all their risk areas. The problem with a very long IPS is that the meaning can get lost in the language and it can be open to legal interpretations in the case of investment losses or errors. It's a good rule of thumb to keep it simple, use bullet points where the details need to be highlighted and make certain that the document is reviewed at least annually to make sure it still applies.
How Long Should It Be?
While there are no direct rules on how long an IPS should be, you can expect between three and eight pages to cover the needs of most individual investors. A document any longer than that will lead to complications; a document any shorter than three pages may just gloss over key areas.
The IPS is an excellent way to come to a long-term agreement on how you or an asset manager will manage your portfolio. If you avoid the common pitfalls many investors and investment managers make when drafting your IPS, you will have a time-tested road map for the future of your investments. (Risk is a vital component of any investment strategy. Discover your risk tolerance and understand the factors to consider when creating your investment portfolio. Check out Get Personal With Your Portfolio.)