When traveling to unfamiliar territory most people will take along with them roadmaps (the more technical among us might even use a global positioning system). When navigating through the investment world maze, having an Investment Policy Statement (IPS) can help you and your advisor stay on the right path.
The IPS is a document to help memorialize your investment risks, objectives, goals, constraints and other relevant factors with your advisor. A well-crafted IPS should cover the following topics: 1) Investment Objectives; 2) Risk Tolerance; 3) Return Goals and Asset Allocation; 4) Liquidity Needs; 5) Tax Considerations; 6) Legal Considerations; 7) Other Constraints.
- Investment Objectives: Identifying the investment objectives are the first order of business for any client. Objectives are typically broken down in such categories as 1) aggressive growth; 2) growth; 3) growth and income; 4) balanced portfolio; 5) income, and 6) capital preservation.
- Risk Tolerance: The investment objectives identified above will have a significant bearing on the risk tolerance. It's important to insure that the risk tolerance is properly aligned with the investment objectives. An investor with an aggressive growth investment objective is willing to assume more risk than an investor who is seeking current income.
- Return Goals and Asset Allocation: Determining the optimal asset allocation is, in part, driven by the return goals established by the investor. Asset allocation is crucial. Studies have suggested that a portfolio's asset allocation is the single most important determinate of potential investment return. A carefully crafted IPS will provide a guide to the asset allocation. For example, an investor seeking a balanced portfolio with a slight growth emphasis with limited liquidity needs might select an asset allocation range outlined below:
Proposed Asset Allocation
| Asset Category |
Target Allocation Range |
| Cash and Cash Equivalents |
5 % +/- 5% |
| Fixed Income (bonds, preferred stocks, CDs, etc.) |
35 % +/- 10% |
| Common Stocks (Equity) |
60% +/- 10% |
To provide some flexibility, a target asset allocation range is advisable. Validated by historical results, advisors assume that common stocks will generally have higher average annual returns than bonds and cash. If the assumptions call for stocks to return over the long term 10% and bonds 6%, then an investor seeking a 9% annual rate of return would have an asset allocation of 75% stocks and 25% bonds [(0.75 x 10%) + (0.25 x 6%) = 9%].
- Liquidity Needs: Another important consideration is the amount of liquidity an investor needs from the portfolio. Investors with large liquidity needs should have a higher percentage of their assets invested in income-producing securities and adequate cash balances. For younger investors with IRAs, the liquidity needs are generally minimal since tax penalties for distributions prior to age 59 ? can be hefty. It's not unusual for a client with multiple accounts to have different liquidity needs for each account.
- Tax Considerations: Taxes can have a significant impact on your portfolio's performance. For investors with taxable accounts, an important factor to consider is managing the portfolio in a tax-efficient manner. Large capital gains, for example, can eat away at after-tax portfolio returns. Discussing how taxes are addressed within the context of managing the portfolio is an important part of the IPS.
- Legal Considerations: Many institutional investors, such as large pension plans, need to follow strict legal guidelines in the management of pension plans. Likewise, some individual investors are restricted from buying and selling employer stock. It's important to make clear in the IPS the precise restrictions in order to comply with the legal requirements.
- Other Constraints: Investors will occasionally place their own restrictions upon their investment accounts. For example, investors might wish not to invest companies that market tobacco or alcohol. Other investors prefer to invest only in 'socially responsive? companies. Having these desires included in the IPS will help the advisor construct a suitable portfolio.
Summary
The time spent in creating a sound IPS is a good first step when working with an advisor. It's a roadmap that will help you and your advisor reach your ultimate investment destination.
