The past few months have been a wild ride for the stock market. Market strategists, technicians and economists will debate the reasons for the volatility, but what is even more important to clients and their trusted advisors is having a plan in place to help navigate turbulent times. One step to keeping a client on track towards achieving their financial objectives is developing a suitable Investment Policy Statement (IPS).
An IPS is important for all investors regardless of age, complexity of portfolio or level of assets. A proper IPS will help ensure that a client’s money is being managed according to their wishes and will insist in keeping them on course to reach those goals.
Contrary to popular belief, there is no such thing as the perfect IPS. An IPS can be a few paragraphs long or a 20-page document. It may cover completely different issues for different clients. The important thing, however, is that the client has one and that it includes the following core components:
- Financial goals: The main purpose for investing is to achieve a client’s financial objectives. A client’s goals can vary significantly based on the type of client and the level of assets. Goals may include retiring at a certain age, maintaining a particular lifestyle, legacy planning, charitable pursuits, funding grandchildren’s educations and the list goes on. These goals can often be forgotten through market gyrations or personal challenges. However, if practitioners clearly define their client’s goals in an IPS, it may help ensure that all parties remain focused on the end goal even during the most chaotic times.
- Time horizon: A realistic understanding of when a client needs their money is one of the most important factors in determining the suitability of various investments and the overall makeup of their portfolio. A client with a three year time horizon will typically have a very different portfolio than a client with a three decade time horizon. The recommendation of each asset class depends heavily on fleshing out the realistic time frame for the client.
- Risk tolerance: When the market goes up, everyone wants to own stocks. When stocks go down, short-term bonds become an investor’s favorite asset class. The movement of the markets can cause every client, no matter how sophisticated, to become temperamental with drastic shifts in their risk appetite. An advisor should spend a significant amount of time upfront to get a handle on where a client stands on the risk spectrum. This may include discussing various market scenarios or filling out an in-depth questionnaire. Regardless of the method used, if the proper amount of due diligence isn’t done, it can lead to crafting the wrong strategy from the onset.
- Liquidity requirements: The level of liquidity in an investor’s portfolio is equally important to both institutional and individual clients. Institutional portfolios may be relied upon to meet budgetary needs or possibly required by law to spend a certain amount of money every year. Individuals, on the other hand, may have regular personal obligations throughout the year that they need to plan for. Regardless of the type of client or their specific liquidity requirements, having a conversation to understand their liquidity needs is essential.
- Income needs: Many investors have income requirements, but the method of obtaining that cash flow may be very different. An advisor should determine the level of income that is required, if that level of income is sustainable, and the optimal method of generating that income. If a client is tax sensitive, he may want to explore municipal bonds. If a client has a longer time horizon then dividend growth stocks may make up a portion of their portfolio. The client may also want to explore a diversified approach to generating the cash flow they need utilizing, interest, dividends and capital gains. Determining the amount of money that is required and the right strategy to generate it, is one of the most important issues many client’s face.
- Special guidelines: One of the biggest mistakes practitioners make is neglecting to ask the client if they have any special instructions that should be adhered to. It’s important to remember that every client is different and their parameters may be unique. A client may have specifications that are personal and religious rather than financial. For example, Muslim clients may have restrictions as it relates to “haram” or forbidden goods. They may have additional concerns with “riba” or interest. Similar concerns with interest may come up with Orthodox Jewish clients who refer to these restrictions as “ribis.” Charitable giving is also an important component in many cultures and should be factored in accordingly. Not all special guidelines are religious. In fact, over the years many investors have opted for portfolios that are conscious of the environment, social concerns, and display good governance. Regardless of the customization that is required, the most important step for the practitioner is to ask these questions. Something that may seem insignificant can be the most important item on the client’s agenda.
Despite the importance of getting these elements of an IPS correct when first engaging with a client, it should still be viewed as a living document and not one that is set in stone. All of the above mentioned criteria may change due to changing life circumstances. It’s imperative for advisors to take the time every year to revisit a client’s IPS to incorporate any updates into their plan. Including the clients other trusted advisors in the discussion is also recommended to ensure that all advisors are working towards the same goals. This collaborative effort along with regular reviews should help keep the client and their advisors focus on what’s important irrespective of what is happening in the market.