Investment Policy Statement for Individual Investors
Abstract
An investment policy document is a formal agreement between an investor and a portfolio manager that defines the goals, strategies, and guidelines for managing the investor’s assets. It is important to have a written investment policy document because it helps to align the expectations and responsibilities of both parties, to reduce the risk of errors or misunderstandings, and to provide a framework for evaluating the performance and suitability of the portfolio. An investment policy document typically consists of five main parts: the investment objective, the asset allocation, the risk tolerance, the structure and the governance structure. The best practices for creating an investment policy document include: conducting a thorough client discovery process, setting realistic and measurable goals, diversifying across asset classes and regions, avoiding complex or costly products, reviewing and updating the document periodically, and consulting with a qualified financial advisor.
Time to read: from 7 minutes.
Level: Fundamental.
Category: Information.
Investment Policy: The Key to Successful Investing
Investors often incur financial losses not due to market prowess but rather from consequential errors. Understanding market dynamics, the interplay of luck and skill, the influence of compounding, and the impact of behavioral biases and emotions on investment decisions is crucial. Caution is advised against pursuing trends, succumbing to herd mentality, and reacting excessively to transient market fluctuations.
Success in investing lies not in attempting to outperform the market but rather in abstaining from such endeavors. Investors are better served by focusing on establishing attainable objectives, mitigating risks, diversifying their portfolios, minimizing costs and taxes, and adhering to a disciplined and patient approach.
An investment policy serves as a strategic framework delineating guidelines and objectives to achieve investment goals. It acts as a safeguard against emotional or impulsive decisions that may adversely affect the portfolio. A structured approach to creating an investment policy involves:
Crafting an investment policy statement (IPS): A concise summary outlining overall investment objectives, risk tolerance, time horizon, liquidity needs, and relevant factors. It delineates roles and responsibilities for the financial advisor, custodian, and investor.
The Components and Benefits of an Investment Policy
Define the structure:
Specify key responsibilities and actors.
Establish a "standard of care" for advisors.
Identify a risk management structure.
Delegate responsibility for monitoring and reporting.
Document acceptance of the IPS.
Governance:
Define responsibility for determining, executing, and monitoring investment policy.
Outline the process for reviewing and updating the IPS.
Specify responsibility for engaging and discharging external advisers.
Asset Allocation:
Assign responsibility for determining asset allocation, including inputs and criteria.
Allocate responsibility for risk management, monitoring, and reporting.
Investment, Return, and Risk Objectives:
Define overall investment objective:
State return, distribution, and risk requirements.
Specify investor risk tolerance.
Describe known behavioral biases of the investor.
Risk Management:
Establish performance measurement and reporting accountabilities.
Specify metrics for risk measurement and evaluation.
Define the process for rebalancing portfolios to target allocations.
Additionally, understanding how to select, monitor, and evaluate investment managers, along with scrutinizing their performance and fees, is essential.
Investing is a challenging endeavor, but minimizing errors and adhering to a sound investment policy can tilt the odds in favor. The advice is to embrace a long-term perspective, maintain humility and realism, and find satisfaction in the investment process.
References:
CFA Institute. Elements of and Investment Policy Statement for Individual Investors. 2010.
Recommended Readings:
Ellis, Charles. Winning the Loser's Game: Timeless Strategies for Successful Investing, Eighth Edition. Chicago: McGraw Hill, 2021.
Malkiel, Burton G., and Charles D. Ellis. The Elements of Investing: Easy Lessons for Every Investor, 10th Anniversary Edition. Wiley, 2021.
