An investment policy statement will keep you on track
Kevin Greenard and Keith Greenard
Province
Would you build a house without a plan?
Imagine building a house without a set of plans. How would that house look if you randomly selected flooring, furniture and window coverings without regard to how they would look together?
It certainly can be done, but we all know that when building or decorating a home, it is best to follow a plan. Once it is put in place, the results can be spectacular.
Too often investors select investments without considering the other investments within their portfolio. Does purchasing the new investment increase or reduce the risk to the portfolio? Does it increase the return potential or reduce it? Does it complement the other investments?
The equivalent to a blueprint for building a home is an Investment Policy Statement. Ideally an IPS should be laid out in advance of the portfolio’s construction. However, an IPS can be done at any time — call it a renovation if done after the fact.
Developing an IPS normally begins with the investment adviser asking the client to answer a series of questions. The adviser should review the answers to these questions with the investor and clarify any inconsistencies. The responses, along with notes made during the discussions, are the foundation of an IPS.
An IPS is part of a disciplined approach that attempts to remove some of the emotional component of investing. Uncertainty about the markets, fear of losing your money and confusion as to what is the best course of action during volatile market times can cause investors to abandon the plan. Sticking to the IPS during difficult times is critical. As we all know, we cannot individually control the market, but we can control how we react to it. An IPS can help manage those bumpy times.
The easiest way to look at risk tolerance is by the percentage of equities in the account. An investor who is averse to risk would have a lower percentage of equities. Such an investor should have a larger proportion of GICs, treasury bills and investment- grade bonds in the portfolio.
As fixed-income investments are not as volatile as equities, they are a key component for those who have capital preservation as a primary investment objective. Most investors desire total returns greater than those currently offered by fixed income and are willing to hold some equities.
Every investor reacts differently to volatility. A risk-tolerant investor typically has a longer time horizon, high annual income, high net worth and multiple sources of income. The typical investor who is risk-averse would have a shorter time horizon, be retired or approaching retirement, have a fixed income, low to moderate net worth and limited sources of income.
These general rules do not apply to everyone. This is why a customized IPS is necessary for each investor.
Determining the balance of cash, fixed income and equities is ultimately the decision of the investor. An IPS is not set in stone — changes may occur with time, life-changing events and investment experience. Some advisers may recommend increasing or decreasing the fixed-income component during certain economic cycles.
One rule of thumb used by some advisers is that the fixed-income component should reflect one’s age. A 20 year-old investor should have 20 per cent in fixed income, while an 80-year-old investor should have 80 per cent in fixed income. This method of determining asset mix is simplistic but does show how an investor should have a larger fixed income component as he or she gets older.
It takes time and patience to build a house; ditto with a portfolio. Once built, it requires maintenance. The IPS is a plan, not an immediate reflection of how the portfolio will look on Day 1.
© The Vancouver Province 2005
