The purpose in having an Investment Policy Statement (IPS) for your portfolio is to give you a greater understanding and control of your investments including greater control in your investment decisions, your portfolio’s volatility/risk levels, and your investing success.
Why should you bother spending the time creating an IPS? Because creating savings is an ongoing habit. There is a high probability that you will buy more than just one individual investment. In fact, if you are saving on an ongoing basis, contributing to an RRSP, TFSA, taxable savings account or an RESP account will become regular activities. These contributions will need to be invested on a regular basis leading to buying and holding numerous individual investments (mutual funds, Guaranteed Investment Certificates (GICs), common shares, preferred shares, Exchange Traded funds (ETFs), bonds, etc.).
If you're going to be making individual investment decisions on a regular basis, how do you ensure that today’s decision compliments yesterday’s decision? How do you make sure that you are not taking on too much investment risk? How do you know if your investments are helping or hurting your progress toward your savings goal?
Simply buying an investment and hoping for the best is not a recipe for investing success. Your investing decisions should be based upon a consistent, reliable and well-defined plan. In the investment industry, we refer to this written plan as your Investment Policy Statement (IPS).
Consider for a moment, without an investment plan, how are you going to reach your financial goals? How are you going to know if your investments are helping or hurting your progress toward your financial goals? Can anything be worse than working hard, saving a little bit every month, only to wake up ten years down the road to discover that you have less money than you saved? To discover that you are ten years older, ten years closer to your goal and your investments have not helped, but hurt your progress?
The purpose in creating an IPS is to clearly define the following:
- your investment portfolio’s financial goals and purpose
- the guidelines and minimum criteria that governs each investment decision
- the direction for the ongoing management and re-balancing of your investment portfolio between asset categories, and
- how you will measure your portfolio’s financial success or failure in achieving its financial goal and purpose
By committing your investing decisions to paper and establishing a set of investing criteria and guidelines, you will enhance your investing success. By establishing a written plan, you will be able to
- maintain a well-defined, clear investment objective for your savings
- ensure that each of your investment decisions are consistent and complimentary with your investing goals
- better manage your portfolio’s investment risk and volatility, and
- measure your investment portfolio’s success or failure to helping you reach your goals
Note: An IPS can be as complicated and exacting or as simple and general as you desire. There are no hard and fast rules for the development of an IPS.
An IPS can be established for a specific investment account type or for all of your savings as illustrated, for example, in the following scenarios:
- You might want to have a separate IPS for your RESP account, as these savings are intended for a specific purpose or goal. Also the investment criteria and Time Horizon for your RESP may be completely independent of other savings you have accumulated within your RRSP, RRIF and Tax-Free Savings Accounts (TFSA).
- Maybe you should have one IPS for all of your savings that are earmarked for your retirement, regardless of where your savings are held (RRSP, RRIF, TFSA or Taxable Accounts). By combining all of your savings into a single investment portfolio, with a single IPS, you can then take advantage of the different income-tax characteristics specific to each account type.
The level of detail really will depend upon you, and your IPS may contain all or just a few of the following attributes:
- Investment Portfolio’s Purpose: Define your investing goal(s) and what the savings held within the portfolio are to be used for in the future.
- Dollar Value of the Portfolio: You should define the dollar amount of the portfolio to be governed by the IPS. In addition, if you plan to add additional savings on a regular basis, this should be stated.
- Scope: If you are accumulating savings within different account types (RRSP, RRIF, TFSA, LRSP, LIF, taxable accounts, etc.) and the savings share the same financial goal, then you should list each account type and the dollar amount held. This becomes important if your portfolio is going to hold interest, dividend paying investments and Growth investments because then you can allocate investments to each account type to minimize your income tax.
- Your Portfolio’s Time Horizon: How long will you be saving and investing to reach your Investment Portfolio’s Purpose? Will the IPS be applicable to your portfolio for 5, 10, 20, or 40 years?
- Expected Investment Portfolio’s Rate of Return: Hopefully, you have already determined your financial starting point, your financial goal, the amount of regular savings to be added to your portfolio and you have calculated the required rate of return that your investment portfolio needs to earn. If not then you are going to be guessing or fantasizing about a number (8%, 12%, or why not 25% per year). Your expected rate of return states the work required from your savings. It is an average annual rate of return, a rate of return you want to earn through a complete business cycle. After going through a good and bad investing cycle, your expected return should average to this rate of return on an annual basis.
- Investment Approach: Are your savings to be invested conservatively, aggressively, or a balance between the two? By labeling your portfolio’s investment approach it helps to remind you of your selected investment style (i.e. your investing personality).
- Liquidity Considerations: Will you need to use a portion of your savings/portfolio to buy a new car? A new boat? Renovate your home? Will you need the funds in 2 years, 5 years, or 10 years?
- Asset Allocation:This is where you state the percentage of your portfolio to be invested in the different asset types. Typically, the list of potential asset categories will include the following:
- Cash and Cash Equivalents, - cash balances, money market mutual funds, etc.
- Fixed Income – Bonds, Guaranteed Investment Certificates (GICs), Preferred Shares, etc.
- Growth – Common Shares, Exchange-Traded-Funds (ETF), Mutual Funds, Segregated Funds, Real Estate Investment Trusts (REIT), etc.
- Speculative – Commodities, Futures, Options, Inverse ETFs, Penny Stocks, etc.
- Real Estate – Rental Properties, Your Home, Family Cottage, Commercial Property, etc. (Some may not wish to include this category when writing an IPS for their investment portfolio.)
- Business Ownership – Shares in Private companies or Trusts, etc. (Some may not wish to include their business ownership interests when writing an IPS. But they probably should as typically their ownership interest is a major asset and will be expected help fund the financial goal.)
Note: In addition, your asset allocation and the expected rates of returns for each asset type must be supportive of your Expected Investment Portfolio’s Rate of Return. There is no point in stating an expected rate of return of 8% and then allocating 80% of your portfolio to Fixed Income, which might have an expected return of 4.0%. The investment portfolio’s expected rate of return and the expected rate of return for Fixed Income are not supportive of each other.
- Specific Investment Guidelines: State any specific investment restrictions or personal preferences (for example, Socially Responsible Investments (SRI) only, only investments issued by companies/governments from developed nations, no investments in cyclical industries, no liquor or tobacco company investments, only investments that pay an income, etc.)
- Portfolio Diversification: This section is often divided into sub-sections. One sub-section for each asset category identified in your Asset Allocation section. So, for example, your Fix Income Diversification may state that no fewer than five and no greater than ten individual fixed income investments are to be held in the portfolio. Each Fixed Income investment must pay a regular income and must maintain a minimum credit rating, from an established rating agency, of “BBB” and no single Fixed Income investment can represent more than 5% of the portfolio’s total market value.
- Investment Costs: In this section, you set the guidelines for your investment expenses. For example, you might state that you want to keep your investment costs below a certain percentage or dollar amount, each year. Just like any expense, you want to ensure that you are maximizing the value of a service in relation to your expense and investing expenses are no different.
- Monitoring and Re-balancing: In this section, you describe the guideline that you will use to monitor and make adjustments to your investments. Typically, you will include a monitoring time frame (monthly, quarterly, or annual). You will also define the criteria that you will use to initiate a decision to sell and buy individual investments. For example, maybe your re-balancing decisions will be made when the portfolio’s allocation to an individual or asset category is exceeded by a certain percentage. Maybe you invested $2,000 in an investment and it has now grown to $4,000 in value. Do you sell all of the investment or a portion? How are the sales proceeds to be reinvested? Buying decisions are always easier than a decision to sell for numerous reasons and, as a result, setting and committing your sell guidelines to paper is extremely important.
- Performance Benchmark: This is the section that details how you are going to gauge your investing success or failure. How are you going to measure your success or failure? Are you going to measure your portfolio’s annual average rate of return by comparing it to the returns generated by the S&P/TSX 60 Index? Are you going to compare your returns to the average within a class of mutual funds? Or are you going to compare your investment returns to what you need to achieve your financial goal?
- Performance Adjustments: Here you can define what adjustments must be made if your investment portfolio is under-performing or exceeding your chosen Benchmark. What do you do if after three years your portfolio is still under-performing or, worse, losing money? Do you keep repeating the same investment process? Do you revisit your Expected Rate of Return calculation? Do you revisit your Asset Allocation or Investment Guidelines? Do you reassess your selected Benchmark? And, also, what do you do if you are exceeding your Expected Rate of Return? Should you do anything? You should have a plan to handle both a successful and an unsuccessful investment portfolio.
Remember: By planning and writing an IPS, you will enhance your investing success. A well-written IPS can provide you with a clear investing path to follow and it can help to make your investment decisions easier and less complicated. And by knowing the purpose of your investment decisions and monitoring your investing progress, you will gain greater control, comfort and understanding of your investment portfolio.
Your now ready to check out Step 10: Research and Identify the Individual Investments to Purchase