Do you have an investment policy statement?

By Robert B. Wolfe, CFP

In a recent national survey of 3724 physicians, over 65 percent of the physicians polled felt as though they were very dissatisfied with their current financial health. Due to the vast proliferation of managed care and the financial havoc it has wreaked, most physicians have become highly motivated to re-assess their current financial situations. Fortunately for physicians, implementing a successful investment strategy is very similar to the execution of a successful medical procedure. Both processes involve planning, implementation and follow-up.

Like most physicians, I spend a considerable amount of time helping my clients “diagnose” their current situation in an effort to help them define their objectives in specific terms. I then conduct a thorough analysis of all of the relevant factors in order to “prescribe” a strategy to give the investor the highest likelihood of achieving his goals. A well-written investment policy statement is the most integral component of any successful investment plan and is vital to the entire investment planning process. Throughout this article, I am going to use one of my physician clients (we’ll call him Dr. Michael Johnsen) to articulate each facet of an investment policy statement.

An investment policy statement (IPS) provides the foundation for all future investment decisions to be made by an investor. It serves as a guidepost, identifies goals and creates a systematic review process. The IPS is intended to keep investors focused on their objectives during short-term swings in the market and provides a baseline from which to monitor investment performance of the overall portfolio, as well as the performance of individual money managers. An IPS outlines the ground rules of the relationship between the advisor and client. With the IPS, the client can expect to have information prepared that will clearly show them whether or not their investment portfolios are achieving their stated goals and objectives. In addition, proposed changes to the investment plan can be evaluated and reviewed against the strategic policy.

An investment policy statement has four basic purposes: setting realistic objectives, defining the asset allocation policy, establishing management procedures and determining communication procedures.

Setting Realistic Objectives

An investment program should be guided by a rational, consistent policy suited to the investor’s unique circumstances. To establish clear and definable expectations, the IPS should state the investor’s objectives and goals in a concise manner. It should establish: risk tolerance; return requirements; income needs; liquidity requirements; investing time horizon; tax considerations; legal and regulatory concerns; and unique needs and circumstances.

This written investment statement clarifies the overall investment plan, and clearly articulates the client’s investment objectives and restrictions, thus providing a measurable basis of feedback with the client’s advisor. Because objectives and expectations are clarified for all concerned parties, misunderstandings are less likely to arise. An IPS compels the investor and the investor’s advisor to be more disciplined and systematic in their decision making, which in itself should improve the odds of meeting the investment goals.

Dr. Johnsen’s investment objectives. These are the main objectives of his investment program and have been developed in conjunction with a review of his financial resources, financial goals, asset allocation, risk tolerance and time horizon: To make his job optional by the age of 55; to have an annual income from his investments of at least $100,000 (after taxes and in today’s dollars, with an inflationary factor of 4.0 percent), beginning in the year he turns 55; to leave a substantial legacy to his two daughters; to minimize potential tax liabilities; to periodically monitor and revise his portfolio, as required.

Dr. Johnsen’s risk tolerance. His ability to tolerate the uncertainties, complexities and volatility inherent in the investment markets has been considered in the development of his investment program. The main factors that influence his risk tolerance assessment are: age, present financial condition, his specific financial goals, his discretionary income and its variability, his past investment experience.

Defining the Asset Allocation Policy

Once investment objectives are established, the IPS should define the asset allocation strategy by specifying an acceptable long-term asset allocation mix between the various asset classes. It should be designed to provide the highest rate of return commensurate with an acceptable level of risk and portfolio constraints. The IPS should explain how the advisor evaluates the investment vehicles used to implement long-term asset allocation strategy. The IPS directs the investor and investment professionals to clearly concentrate on the investor’s goals and objectives when considering any potential investment opportunities.

Dr. Johnsen’s holding limits. His portfolio was developed subject to certain holding limitations. These are limitations on the minimum and maximum percentage investment in each asset class:

• Large Cap U.S. Equities (15-30 percent)

• Mid Cap U.S. Equities (10-25 percent)

• Small Cap U.S. Equities (5-15 percent)

• Foreign Equities (5-15 percent)

• REITs (0-15 percent)

• Inter-Term Govt Bonds (10-25 percent)

• High Yield Bonds (0-10 percent)

• Cash and Cash Equivalents (5-20 percent)

Dr. Johnsen’s initial asset allocation. Based on his financial resources, financial goals, time horizon, tax status, holding limitations, risk tolerance and expected investment performance a recommended portfolio has been determined. The portfolio balances risk and reward and attempts to achieve the stated objectives of the investment program. The initial asset allocation for Dr. Johnsen’s investment program is:

• Large Cap U.S. Equities (25 percent)

• Mid Cap U.S. Equities (10 percent)

• Small Cap U.S. Equities (5 percent)

• Foreign Equities (15 percent)

• REITs (10 percent)

• Inter-Term Govt Bonds (25 percent)

• High Yield Bonds (5 percent)

• Cash Equivalents (5 percent)

Establishing Management Procedures

To provide a guide for selecting, monitoring and evaluating the performance of those responsible with managing and investing the assets and making changes as appropriate, planning ahead makes it easier for everyone involved when the financial markets become turbulent. Approved decision-making and implementation procedures are specified so everyone concerned will know what to expect. In a deliberate fashion, rather than in the “heat of battle,” decisions can be made as to how things will be done under a variety of changing circumstances and conditions.

Dr. Johnsen’s investment selection criteria. Investment portfolios used to implement Dr. Johnsen’s investment program shall be subject to specified selection criteria and shall be monitored for adherence to his investment policy guidelines, major changes in the portfolios and comparative performance with similar investments.

Dr. Johnsen’s review process. His investment performance will be monitored and reported on a quarterly basis and will be compared against the appropriate benchmarks. The investment program will be reviewed at least annually to make sure that it continues to achieve his stated objectives. Since this investment program is long-term in nature, the periodic adjustments made to his investment program should be small.

Rebalancing Dr. Johnsen’s portfolio. The percentage weighting to each asset class within the investment portfolio will vary. The percentage weighting within each asset class will be allowed to vary within a reasonable range of plus or minus 5 to 10 percent, depending upon market conditions. When rebalancing is required, investment yield and net cash inflows will be used to meet the strategic asset allocation targets. If cash flow is not sufficient to meet the target allocation for an asset class, we will decide whether to effect transactions in order to rebalance the asset allocation.

Determining Communication Procedures

The IPS provides a concise method of communicating the process and objectives amongst all parties involved with the investments, and assigns responsibility for implementation. It provides a ready means to communicate to advisors, beneficiaries and current and future fiduciaries how the investor proposes to go about acting upon his or her duties.

In order to be most effective, an investment policy statement should not be too restrictive and should provide as much flexibility as possible. The wording of the IPS should allow for changes in the following: the client’s financial situation, procedures for modifying the IPS, any material changes at the advisor’s firm and the authority vested in the advisor

An Investment Policy Statement, as you can see, is the first step in diagnosing your current financial health and will set forth a program to help insure that your future will be secure.

Robert B. Wolfe, CFP is Vice President at Compu-Val Investments, a Wilmington, DE-based investment advisory firm specializing is asset management.