Investment Policy Statements

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	A Roadmap for Investing Personal Finance Advisor by Deloitte & Touche OnLine August 4, 1997

An investment policy statement will keep you focused on your objectives.

When faced with investment decisions, many individuals make the mistake of chasing the "hot" stocks or the "best" mutual funds. The process of selecting investments, however, should be based on a sound investment strategy that is spelled out in an investment policy statement (IPS). Such a policy statement provides individual investors the disciplined strategic approach to investing that fiduciaries and investment committees of pension and endowment funds have used for years.

An IPS establishes (and documents) a long-term plan for an investment portfolio, and the framework within which all investment decisions can be made. The statement communicates the investor’s goals and objectives, risk tolerance, and long-term strategy to investment advisors, and establishes the guidelines for implementing and monitoring the plan. Other benefits of an IPS:

Helps remove emotion, anxiety, and second-guessing from investment decisions.
Keeps the investment process focused and intact during periods of market upheaval.
Provides a plan for the investment of future cash flows (for example, when the investor receives a bonus, exercises stock options, or takes an IRA rollover, a plan is in place for investing the funds).
Establishes guidelines for investing assets in an estate (particularly important if the executor or heirs are not sophisticated investors).

Purpose and Background: Include in the IPS an explanation of the purpose of the portfolio (e.g., long-term growth for retirement). The policy statement should note:

The size of the portfolio (including planned additions and withdrawals).
The tax status of the portfolio (whether the investment funds are taxable, tax-deferred, or tax-exempt).
The amount of time the portfolio can be committed to the investment policy.

Investment Objectives: A typical objective for an investment plan is to maximize returns while assuming a reasonable level of risk, and to minimize costs and income taxes. The IPS should specifically address investment objectives -- set a target annual return, both nominal and real (after inflation). Risk tolerance should be stated in terms of acceptable volatility (range of returns around the target return). Other objectives that should be discussed in an IPS include (1) specific income needs, (2) liquidity requirements, and (3) any lump-sum cash distributions.

Asset Allocation Strategy: Which investment categories you will invest in, and in what proportion, is set forth in an asset allocation strategy. This strategy should be discussed in the IPS. To establish a sound asset allocation strategy, the investor provides guidelines regarding his/her tolerance for risk, asset class preferences, investment time horizon, and desired rate of return. These guidelines will be specific for each investor -- there is no "correct" asset allocation for any particular situation. Before setting an asset allocation strategy, it is important the investor understands the principle of risk and return, and the allocation strategy’s potential impact on the individual’s financial situation.

Studies have shown that over 90% of the variability of portfolio returns can be explained by asset allocation strategy. Only a small amount of a portfolio’s variability is due to security selection, market timing, and/or random luck.

The IPS should also indicate how often the investor plans to rebalance the portfolio (rebalancing can involve transactions that have associated costs and generate taxable income).

Portfolio Management Guidelines: The IPS includes parameters for the investment manager(s) to follow. Portfolio management guidelines should not be so restrictive that the professional manager cannot do his/her job. Rather, guidelines could:

Limit the amount that may be allocated to any one security or industry (to ensure proper diversification), or
Indicate securities or practices that are not acceptable (e.g., minimum quality bonds, socially responsible investing).

Money Manager or Mutual Fund Selection: The IPS also establishes the process/criteria for selecting money managers or mutual funds. The guidelines should set specific qualitative and quantitative requirements -- for example, conformity to a specific asset class and style, a minimum tenure of the current manager, historical performance standard relative to a representative index/peer group, and/or fund expense standards relative to a peer group.

Control and Review Procedures: Include in the IPS a process for ensuring adherence to the investment policy, and monitoring the effectiveness of the policy. The duties of the various parties to the process should be delineated -- the IPS could require the generation of monthly portfolio reports and quarterly performance reports. Additionally, the IPS could establish specific criteria against which each fund manager will be evaluated.

These are some thoughts to consider when developing an investment policy statement. A Deloitte & Touche LLP investment advisor can assist with the creation of your IPS.