An Investment Policy Statement. or IPS, is the foundation of an appropriate investment strategy. It gives your client an overview of the whole investment plan: the asset allocation, the investment objectives, the risk tolerance, the asset management approach and the ground rules for communication between the RIA and the client. A good IPS defines your clients’ time horizon, liquidity requirements and income needs, return requirements, and tax concerns. It also notes any special needs and circumstances. The IPS is a more comprehensive picture of the investor than the brokerage new account profile. That is because it is usually preceded by a financial plan or at minimum, a thorough needs/risk tolerance questionnaire. This process helps to insure that the investment advisor meets their responsibility to “know the customer”.


Most of all, the client’s IPS states the marching orders of the RIA or the parameters by which they invest. For example, the client might consider themselves to be some type of a value investor, a growth investor, a conservative investor, or even (incredibly) a speculative investor. With that preference established, their IPS defines a long term asset allocation for them: a way to assign their invested assets to diverse asset classes in a way that suits their preferred investment style.


The emphasis here is that this IPS is created by them and their financial team or consultants; through a dispassionate process where the investor style that reflects their core risk tolerance is then carefully aligned with an asset allocation of investment solutions that can then deliver a range of performance (returns) over their lifetime or chosen time period.


 Think of an IPS as a long term GPS for the client’s portfolio. The goal is to set the asset allocation in a way that can potentially give the client the highest possible rate of return corresponding to an acceptable level of risk for them. When this is done in a dispassionate process, it affords them an enhanced ability to pragmatically and proactively make important decisions even in “highly” emotional and volatile environments (like for the years of 2000 – 2001 or 2007 – 2008).


The IPS keeps clients from getting “off track” when it comes to investing. Over time, through a consultative process, the client and their investment advisor keep an eye on the portfolio, to see that the assets inside it stay within the allocation boundaries set by the IPS. While also assessing the changing nature of investment markets to measure how the risk/return ratio for their investment style compares with the current market trends and what if any changes are necessary for them.


This is why quarterly reviews are so essential. This is the time for the investor’s investment objectives and risk tolerance to be re-examined. Periodically, their portfolio may need to be rebalanced. Here’s why. As months and years go by, the ups and downs of the investment markets will throw the asset allocation slightly or dramatically out of its original alignment. As an extremely simple example, let’s say the client starts out with 35% of their assets in U.S. large caps, 15% in U.S. mid-caps, 15% in U.S. small caps, 20% in institutional companies and 25% in bonds. Suddenly, small cap stocks have a great couple of quarters or year, and thanks to the great returns, they wind up with 21% of their assets invested in small caps and only 19% in bonds. That’s great, right?


Well, yes and no. What’s actually happened is that the client’s long-term risk has increased along with their return they have received in the short-term. A greater percentage of their assets are now held in the comparatively risky component (small cap stocks), versus the lower percentage now held in the typically less risky bond component. So while the short-term gains have been great, it may be time to rebalance according to the parameters set by their IPS so that they can help reduce their risk exposure.


For individual tax-deferred retirement accounts or institutional accounts that are non-taxable, this is easily done: they simply transfer assets among accounts to restore the target allocations. Future contributions occur according to the IPS parameters.


 When it comes to taxable investment accounts, it is usually though not always best to ramp up future contributions to the underweighted funds rather than sell positions of a fund and trigger taxes. However, since the goal is always to preserve capital I personally would lean towards incurring some taxes as opposed to losing capital in the effort to prevent paying taxes. But ultimately that decision must be approved by the client – with the RIA’s help, of course.


Always remember that your clients are investors, not gamblers. Their IPS is designed to help them invest in a consistent, appropriate way, a way that matches their preferred investment style. Without an IPS, they invite impulse, emotion and a short-term focus into the picture. The RIA has limited control on expected future returns, while he or she can exert significant influence on the level of risk that is undertaken.


 This should be kept in the forefront of the client’s thinking about the long-term value of an IPS and how theirs is working today.