Plain Speaking: A Look at an Investment Policy Statement

From Hayden's files, here's how he explains what he'll do for one of his clients.
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Before you have anyone manage a portfolio for you, he or she should give you an investment policy statement that outlines such things as your objectives and risk tolerance. These statements tend to be filled with management jargon and a lot of technical principles that mean more to the investment manager than a client. When I write these statements for my clients, I try to use plain language that, hopefully, is meaningful to them. I thought I would share with you an actual statement I wrote for a couple who will, understandably, remain anonymous:

Investment Policy Statement

For Mr. and Mrs. Anonymous

Purpose

The purpose of the Investment Policy Statement is to outline the general framework for which assets in your account may be invested to help attain your stated goals and objectives while taking into account your risk tolerance level and your unique needs and preferences.

The Investment Policy Statement is not a contract, nor does it represent a commitment for you or Hayden Financial Group, but rather, it establishes the guidelines, methods and investment criteria which will be observed in the management of your account.

Your Investment Objectives and Time Horizon

A successful investment plan is one that starts with a clear, well-understood objective. Your objective, with the investments I will be managing, is to achieve a 15% per year compounded return over a three-year period.

That would mean that the $750,000 in the beginning would grow to $1,140,656 in three years. This assumes reinvestment of all capital gains and dividends.

The question you have asked is a very reasonable one: "Is it possible to achieve that goal?" The honest answer is, I don't know, because it is impossible to predict the future. It's impossible to know what the various markets are going to do over the next three years. If we use the historic norm for large-company stocks, we end up with a compounded average return of about 11% a year since 1926, according to an authority by the name of

Ibbotson

. For small-company stocks, it is closer to 12% to 13%. We need go back only to 1992, 1993 and 1994 to find a three-year period in which the

S&P 500

index averaged only about 6% per year

There are many stocks and stock mutual funds that have averaged a lot more than 15% a year for five years. Maybe that is because there is a Hegelian struggle going on between Old Economy and New Economy stocks (forgive me, I was a philosophy major). Hegel said progress evolves through a synthesis of two opposing viewpoints. The Old Economy is the original viewpoint, the New Economy is the antithesis of the old, and the two will result in a world that synthesizes the best of each.

The revolution that has only begun to transform our world cultures and business environment creates an ongoing stream of unique investment opportunities. These investment opportunities are larger in numbers and dollars than ever before, and we want to tap into them to help you reach your objectives. In another era, you would hardly have a prayer of reaching your objectives. In this era, I think we have a decent shot at it.

I am sure you understand that because of securities laws, I have to be very careful what I say or even imply. There is no way I dare imply we will achieve these objectives for sure. No guarantees! Everything is done on a best-effort basis.

I am sure your objectives cannot be met by using a classic asset-allocation strategy or aligning your portfolio with all the great academic studies that have been done. If we take the safe route of low betas/high alpha, low standard deviations, high Sharpe ratios,

Editor's note: See Brenda Buttner's Which Mutual Fund Risk Measures Really Matter

and in general place the focus on deep value, we may not come close to your objective. At least, it would not have worked over the last five years.

If there is a radical shift in investor sentiment from growth stocks (stocks expected to grow quickly in value) back to value stocks (stocks selling at an attractive price relative to their intrinsic value), then classic allocation strategies will work again. But that is like saying that even though

Warren Buffet

lost about 50% last year, he is going to make it all back soon. If he does, then we will be confronted with a new opportunity called a "shift to value," and I hope to the extent necessary we can make that shift, too.

I will do my best to help you reach your goal. We will be faced with constraints, extreme volatility and above-average risk. There will be losses and gains (again, no guarantees!), but hopefully, no panics along the way. I want to do my part to help you build a $1.5 million dream house and have $500,000 a year of income.

More specifically, your money will be invested in all equities, using mutual funds. The risk will obviously vary. In terms of volatility, it should not exceed a 1.20 beta. Please understand what that means: In an up market, that implies the equity should perform 20% better than the market, but it also means it would go down 20% more than the market in a down market. Of course, that is an oversimplification of risk, but it gives you an idea of how it works.

Over a five- to 10-year period, the vagaries of the market generally smooth out a bit and the risk is reduced. While you have a specific three-year objective, you also have told me you will have this money invested over a long period of time -- 10 years or more. That is very important, because in the short run, the market is very unpredictable.

Your Personal Benchmark

There is no standardized benchmark for your portfolio. For instance, the

S&P 500

is inappropriate, because only some of the fund managers use that as an objective. The acceptable benchmark for small-cap funds is the

Russell 2000

, and for the overall market, the

Wilshire 5000

.

We do expect each fund to meet the benchmark for its own particular style, as defined by

Morningstar

.

Investment Process and Selection

The investment process includes an allocation to the various categories of mutual funds. The process emphasizes the critical importance of each fund manager and the styles within which they manage. Each manager has a distinct investment philosophy. Most can be identified as focusing on value or growth styles or a blend of the two. They also specialize in investing in large, medium or small companies. Mutual fund managers are expected to meet or exceed the benchmark performance (as defined by Morningstar) for their respective asset classifications.

We may suggest changing funds from time to time. The reasons for a change include, but are not limited to, the following (the first five circumstances a fund manager can control; the second four are beyond a manager's control):

  • Asset size changes radically.
  • Investment style changes.
  • Poor stock selection.
  • Change of management.
  • Unsuitable performance record.
  • Change in the global investing climate.
  • Change in the economic outlook.
  • New tax laws or shifts in the political climate.
  • A change in your goals.

Periodic Adjustments to Your Portfolio

Every quarter, you will receive a report which will detail the performance of your account for the quarter, year and from its inception to date. The quarterly report also summarizes your realized gains and losses and unrealized gains and losses.

When your financial situation or objectives change, make sure to review these changes with me. We may need to make adjustments in your portfolio based on any change.

That concludes the kind of IPS I like to do for a client. It is designed to "tell the time" but not take the watch apart to analyze the inner workings. Please

let me know what you think. Thanks, and have a great week.

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

Hayden4t9@aol.com.