The Investment Policy Statement
An investment policy statement (IPS) is the road map for investors. It should outline and prescribe the strategy for a prudent and individualized investment philosophy. A written and signed statement is needed because it allows the investor to explicitly articulate a well thought-out long -term investment policy, setting out the investment management procedures and long-term investment goals. Writing and signing the document is likely to assist in protecting the investor from ad hoc revisions that are caused by emotions generated by noise of the market----emotions such as greed and envy in bull markets and fear and panic in bear markets.
Academic research has found that all to often investor's succumb to those emotions, almost invariably to the investor's detriment. A written policy statement helps assure that rational analysis is the primary basis for investment decisions, thus avoiding mistakes caused by emotional decision making. In addition, for investors who believe that they do not have the time, ability, knowledge, discipline, and perhaps even the interest to manage their own portfolio, the prudent strategy would be to delegate that role to an advisor who does. The IPS will be the road map for the advisor to follow. Despite the importance of the IPS, it is our experience that only a very small percentage of all investors whom we meet that work with stockbrokers as their investment advisor have a written IPS. Then again, based on our conversations with ex-stockbrokers, over 90 percent of their training related to sales, not investments. Another explanation for this phenomenon might be that if investors had a well-thought-out plan, then they could not be sold products that don't fit into the plan---and brokers would make less money.
Consider the following question: How can investors without an IPS effectively analyze any investment decision without knowing how it impacts an overall strategy? Of course, they cannot. Perhaps that is one reason that investors who work with stockbrokers generally have such poor results.
To summarize, the IPS can be thought of as a contract with yourself, and your investment advisor, if you choose to work with one. Its purpose is to:
* Establish reasonable expectations, objectives, strategy, and the implementation guidelines for the investment of the portfolios assets. These should be based on the three branches of the IPS decision tree- the investor's ability, willingness, and need to take risk.
* Set fourth an investment structure detailing permitted investments and the desired allocations across asset classes. Arriving at the correct asset allocation is a critical part of the process, as it determines virtually all of the risk and rewards of the investment portfolio. Thus it is essential to get the allocation right.
* Serve as a reference over time to provide long-term discipline for an established plan.
The fixed-Income IPS
The fixed income IPS should begin with defining your goals. Before you can decide on what fixed-income investments are appropriate you must decide on wether the main objective of the assets is to generate income or to provide stability of principal. Once that is accomplished, the type of assets should be defined. The next step is to determine the investment horizon. The horizon should be aligned either with the need for cash flow or the need to diversify the risks of an equity portfolio (in which case maturities should remain short-term). Decisions must be made as to appropriate maturities. The next step is to set guidelines for acceptable credit ratings.
The following illustrates the issues that a fixed-income IPS should address as well as providing an example. Note that, as we have discussed, there is no one universally correct solution. The policies described here, therefore, are merely examples that may or may not be the same ones you would incorporate into your own IPS.
* The type of investment vehicles: Both individual bonds and low-cost and passively managed mutual funds will be used to construct the portfolio.
* The average maturity: The average maturity of the portfolio will not exceed five years, but cannot be less that two years.
* The maximum maturity of any one bond: The maturity of any one bond cannot exceed ten years.
* The minimal acceptable credit rating: The minimal acceptable credit rating is A
* The maximum allocation for each credit rating: Bonds with a credit rating of A cannot exceed 10 percent of the portfolio, and bonds with a credit rating of AA cannot exceed 20 percent
* The maximum allocation for any individual credit: With the exception of bonds that have the full faith and credit backing of the U.S. government agencies or GSEs, no single issuer can exceed the following: AAA-rated bonds 20 percent, AA- rated bonds 10 percent, and A-rated bonds 5 percent.
* The types of instruments that are excluded from eligibility:
Neither MBS nor hybrid securities can be purchased.
* The minimum and maximum block size: Individual bonds should not be purchased in amounts less than $50,000 nor greater than $250,000. A maximum is recommended to ensure sufficient diversification of credit risk. A minimum is recommended because if there were an opportunity to harvest a loss a small block would lead to high trading costs.
It is critical that investors understand that even having a well though-out plan, and a signed investment policy statement, is only necessary condition for being a successful investor. The sufficient condition is having the discipline to stay the course and ignore the noise of the market and the emotions it causes, such as green and envy, and fear ans panic, so that you adhere to your well-thought-out plan. The IPS should be reviewed on a regular basis. One reason for doing so is to remind yourself why you adopted the specific strategy. A second reason is that an IPS should be living document. Personal circumstances can alter one's ability, willingness, and need to take risk.
