The financial services industry spends lots of time talking about the personal financial plan, and how everybody should have one.  They spend far less time on the other document widely recommended by financial pros, the “personal investment policy statement”(also called the “personal IPS”).   We should take a moment to evaluate the potential merits of this underappreciated gem.

What is the point of an investment policy statement?

The most common analogy used in the description of the personal financial plan is the analogy of a road map.  If the financial plan is the road map, the investment policy statement is the “rules of the road” handbook you get in drivers ed.  It tells you how fast you should be going on different kinds of roads, what to do when certain warning signs are displayed, how to respond to adverse driving conditions.   No matter how well you follow the road map, driving recklessly and having a crash is a serious setback for your trip. 

A properly developed policy supports a consistent long-term investment approach, and it helps prevent the kind of “off-the-cuff” changes that many investors make.  The operative theory behind their creation is that you can study certain relevant issues in advance, and make decisions about them before you are pressed to decide how to handle them “in the heat of the moment.”  What do you do when the market is falling?  Check the policy.  What does it say that you do?   Should you put your IRA into real estate, because it is taking off?  How much did you determine to allocate there in your investment policy?  That should give you the answer.  If your policy is well thought out, properly constructed, understood and followed, then it can be a useful risk management tool.  It does not prevent you from losing money, nor does any policy anticipate every situation.  It can become better over time, as you add to it and amend it as time goes on and you think about different issues that can affect you.  In addition to creating robust investment plans, you can also think about how much flexibility you want your plans to have, in order to take advantage of opportunities that arise.  I strongly advocate building downside protection first, particularly in regard to potentially serious conditions.  I think opportunistic investment policies are fine, although we use them sparingly.  We strive first for policies that are durable and “robust,” (in the sense meant by Nassim Nicholas Taleb) which is to say that they are resilient.  If we have a client comfortable building plans that are resilient, we can then advance to plans that offer more opportunism if the case warrants. 

How complicated should your Investment Policy Statement be?

A good question.  Like most good questions, the answer is not necessarily simple.   I think the simplest investment policies are best.  Simple, repeatable, easy to follow, and easy to monitor investment policies are more likely to be useful than ones that are the opposite.  If you have a professional financial advisor equipped to execute more complex policies, then adding complexity is fine.  I would still say only add complexity if the result of adding it and executing it saves you from some real peril.  Having an investment policy that requires constant hedging, and the constant monitoring of your hedges might be critical for some people, and only a nice addition for others.  The time and expense of the policy would lead me to avoid it unless needed.    

Thus, beginning with a simple set of investment policies is probably the way to go.  Over time you can add granularity and complexity as needed.  We provide a template for gathering investment policy information, which you can use.  We are also launching the IPS Help section of our website, with a collection of our talking points about various investment policy decisions (Coming Soon—click here to be kept up to date as these items are released).  In keeping with this, we will have a series of blog posts on granular investment policy topics and support collateral for your own investment policy process.  If you decide the task is worth doing, but don’t want to go it alone, we are available to consult.  

Where does the Investment Policy Statement fit into the overall investment management process?

Different professionals that use IPS documents create them at different stages of the process.  We like to put our IPS generation near the beginning, before we do financial planning.  The basic principle is that you learn the rules of the road before you take a road trip (using that old road map analogy again).  We think that this also prevents us from creating policies to fit plans, rather than the reverse.   Financial plans (rather human beings) have a tendency to follow the path of least resistance.  If we give someone a financial plan that says they might choose portfolio A which is targeted to earn “X”(percent per year on average) over time, or portfolio B to earn 2% less than “X” (again, percent per year on average) over time, in which case to meet their goal they will need to save 5% more per year(totally hypothetically).  Many investors immediately say that portfolio A is the obvious choice, even though the other aspect of that portfolio is that it might have a lot more volatility, and some follow on effects of that, such as the necessity to wait out some downturn at the point when they wanted to cash it in, or other implications.  If they have reached the decision in their own minds that they prefer the risk of portfolio A, because it means they don’t have to set aside the additional 5% per year for the more conservative portfolio, when we go to work on their Investment policies, this becomes a fait accompli.  They choose their risk tolerance based upon a portfolio decision we allowed them to back into.  We prefer to have the risk tolerance and investment policy figured out first, so when a client wants to choose the riskier portfolio in a planning scenario, we have a brake on the process to consider whether it is an appropriate choice for them.  We have in a sense created an automatic governor for the expediency of intentionally choosing more risk than one is comfortable with.     There are enough unforeseen risks in life--and in investing—without making it easy to add more without critical evaluation. 

Is the personal investment policy right for everyone?

I don’t believe in one-size fits all answers.  I believe that informing yourself about the merits of investment policy statements is free, and it might help you manage your finances better.  It might involve a varying degree of time up front, and periodically, but if it helps you prevent a single significant failure, perhaps the time would be well spent.   If you want a comprehensive discussion on the Personal investment policy, we have a white paper available, and we are happy to chat about them if you want.  Feel free to contact us to chat, or download the white paper, and read more.

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