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Draft an Investment Policy Statement

By Scott Keffer

Two years ago, my wife, Beth, and I built a house – for the second time. Would you be surprised to know that the unexpected happened? More than once!

What gave us the guidelines to handle the unexpected? What made decision-making much easier – particularly in the heat of the moment? What allowed us to have a clear understanding of what the final result should look like? What ensured that we could hold the builders to a standard of performance? A pre-agreed upon building plan and blueprint.

Imagine building a house without a building plan and blueprint. Imagine just starting to build and deciding as you go. What would the house look like?

Imagine flying on a plane without a written flight plan. How confident would you feel? Imagine putting your own money into a business that didn’t have a written business plan. Imagine taking a vacation with no idea how to get where you are going.

Now, imagine investing your money without a written investment blueprint. Yet, that’s how most people invest.

The technical name is an Investment Policy Statement (IPS). Why have most people never heard of an IPS, let alone used one to guide their investing?

If you are responsible for retirement plan assets, assets in a trust, or endowment and foundation assets, then you don’t have a choice. You must have an investment policy and it must be in writing. It’s the law.

Investment Policy Statements are required by the Employee Retirement Income Securities Act (ERISA). The Uniform Management of Institutional Funds Act (UMIFA) requires governing boards of endowments and foundations to create an Investment Policy Statement under the standard of “business care and prudence.” Finally, trustees of various trusts are regulated by the Uniform Prudent Investor Act (UPIA). A written Investment Policy Statement contains the items required by the “Prudent Investor Standard.”

Should we be any less diligent with our own money – our own future security?

If I asked you to put this article down and locate your written Investment Policy Statement, would you be able to? Statistics suggest no. If you already have one, you are to be congratulated. Are you using it to the fullest advantage?

Charles Ellis wrote a very profound book on investing titled “Winning the Loser’s Game” Timeless Strategies for Successful Investing. On Ellis’ book, Peter Drucker commented, “This is by far the best book on investment policy and management.” In it, Ellis says the foundation of successful investing is a written outline of what you want your investments to do for you – an Investment Policy Statement.

The Memphis Business Journal’s article, Investment Policy Statement Avoids Investor Paralysis, says this: “If you are dealing with a true consultant, you have a written Investment Policy Statement (or IPS) that provides investment guidelines for any market condition.”

An IPS is the foundation to investment success. Having an objective, written, pre-determined plan for reaching your investment goals, you will avoid the high cost of emotional decision-making during chaotic times in the market and the tantalizing lure of what I call “investment noise.”

“Investment noise” causes confusion, uncertainty and fear. The problem is this: confusion, uncertainty and fear make great news. Therefore, the media loves “investment noise!” Even worse, these strong emotions prompt us to move money often – to try and chase a better return or try and find a better manager – so Wall Street firms love “investment noise.”

“Investment noise” is based upon two popular myths: that you can increase your returns through security selection or through market timing. In other words, the myths “promise” that it is possible for you to increase the return on your investments by either stock picking or market timing.

Stock picking promises that someone – you, your broker, or the latest “guru” – can consistently discover mispriced securities that all the other investment managers have failed to discover. Securities, by the way, that will out-earn the market.

Market timing promises that someone – again you, your broker, or the latest “guru” – can consistently identify when the entire market, or a particular market sector, is mispriced and consistently predict when it will move up or down.

Think about it. Does that make sense? In today’s information environment, how can any one person or organization have a consistent advantage? It can’t happen. It’s the same reason that no professional sports team has an advantage in the draft any longer. One team may gain an advantage once or twice, but no longer consistently. With the way that information flows freely, no one has a consistent advantage.

Stock picking and market timing rely on the premise that our group has created a “system” to out-predict the market – or has discovered “hidden” information that others don’t possess – or has found “secrets” previously missed. Wall Street firms spend tons of money every year trying to convince you that these things are possible.

In his book, Ellis goes on to say this, “For investors, the real opportunity to achieve superior results is not in scrambling to outperform the market, but in establishing and adhering to appropriate investment policies over the long term – policies that position the portfolio to benefit from riding with the main long-term forces in the market.” Further, he adds, “Investment policy is the foundation upon which portfolios should be constructed and managed.”

Most importantly, the Investment Policy Statement focuses on your objectives for your portfolio, including your desired investment returns and time horizons; your need for cash flow and lifestyle desires; and your definition of and tolerance for risk. It also should include roles and responsibilities, legal and ethical restraints, and the monitoring and review process.

One of the most important issues that need to be addressed is risk.

Have you ever been in a car that was being driven way too fast? How about a car that was being driven way too slow? These questions are about risk tolerance – physical risk tolerance.

Financial risk tolerance is the most important single attribute relevant to all your financial decisions. Understanding both your tolerance for risk, as well as your capacity for financial risk are critical components of an effective Investment Policy Statement.

Risk tolerance is how much risk you choose to take. It is a psychological attribute of each individual. Risk tolerance affects how psychologically receptive you are to decisions involving risk – and the degree of anxiety experienced in situations where risk is evident.

Risk tolerance represents a trade-off on the continuum from minimizing unfavorable outcomes to maximizing favorable outcomes, not just an upper limit on unfavorable outcomes. In other words, we are talking about establishing your financial “comfort zone.” If you take “too little risk,” you won’t feel you’re making the most of your opportunities. “Too much risk” and you’re going to be anxious, worried or even panicked.

Risk capacity is how much risk you can afford to take. It, on the other hand, is a financial attribute of your circumstances. Risk capacity is the amount of money you can afford to lose without putting your financial goals at risk. You should not choose a strategy where the worst case scenario involves the possibility, no matter how remote, of a loss greater than your risk capacity.

Unfortunately, the financial industry has missed the fact that testing for a psychological attribute such as risk tolerance requires a special set of skills and disciplines – the skills and disciplines of psychometrics. As a result, even when a process has been used, it has lacked scientific rigor. To properly establish your risk tolerance, a psychometric test (around 25 questions) is required, along with an interview to evaluate the results.

In a recent study by organizational psychologists, Chandler & Macleod Consultants, financial advisers were asked to estimate in advance the risk tolerance of clients. The estimates were then compared to actual test results. Adviser’s estimates were shown to be quite inaccurate. In one-in-six cases, advisers had made gross errors.

A properly drafted IPS will outline both your risk tolerance and risk capacity. After it has been reviewed and accepted, the next step is to put it into action. Your Investment Policy Statement drives the design of the appropriate mix of asset classes and the manager selection process. Once your investment strategy has been put in place, except for rebalancing of the portfolio on a regular basis, the final key is to settle in and enjoy the house that your IPS built. In other words, stick to your plan.

My advice is: don’t build a house without a blue print, and don’t invest one more red cent without first creating an investment blueprint – a properly drafted and implemented Investment Policy Statement. Being successful with your investments – and your financial independence – depend on it.

Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh.

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