Imagine a pilot taking off without a flight plan, attempting to navigate through storms based on "gut feeling." This is how most individuals invest. They buy stocks when they feel confident and panic-sell when they feel fear. The result is almost always a crash.
In professional portfolio management, the "flight plan" is known as the Investment Policy Statement (IPS). It is a formal document that dictates how money is to be managed. Even if you are managing your own money, drafting a personal IPS is the single most effective step you can take to prevent emotional errors.
What is an IPS?
An Investment Policy Statement is a strategic document that details a client’s investment objectives and constraints. It serves as a contract between the client and the portfolio manager (or between you and your future self) to ensure discipline during market volatility.
Why You Need an IPS
The market is a machine designed to transfer money from the impatient to the patient. An IPS enforces patience by pre-deciding your actions.
- Emotional Anchor: When the market crashes by 20%, your IPS reminds you that your time horizon is 15 years, preventing you from selling at the bottom.
- Dispute Resolution: If a professional manager loses money in the short term, the IPS clarifies whether they deviated from the strategy or if it was just normal market movement.
- Consistency: It ensures that investment decisions are not made ad-hoc but are part of a unified strategy.
Components of a Robust IPS
A standard IPS typically contains the following sections:
- Introduction & Scope: Who is the client? Which assets are covered?
- Duties & Responsibilities: Who executes the trades? Who monitors the risk?
- Objectives: What are we trying to achieve (Return) and at what cost (Risk)?
- Constraints: What limitations exist (Liquidity, Tax, Time)?
- Strategic Asset Allocation (SAA): The target mix (e.g., 60% Equity / 40% Debt).
- Review Mechanism: How often will this document be updated?
Step 1: Defining Objectives
The core of the IPS is the Risk-Return profile. This is often where investors are most dishonest with themselves.
Risk Objectives
We must distinguish between two types of risk profiles:
| Concept | Description | Example |
|---|---|---|
| Risk Ability | Financial capacity to withstand loss. Based on wealth, income stability, and time horizon. | A wealthy 25-year-old with no debt has high ability. |
| Risk Willingness | Psychological tolerance for loss. Based on personality and past experiences. | That same 25-year-old might lose sleep if stocks drop 5%. Low willingness. |
Crucial Rule: The risk taken should be the lower of the two. If you have High Ability but Low Willingness, you must invest conservatively, or you will panic-sell. If you have High Willingness but Low Ability (a broke student gambling on options), you must invest conservatively, or you will go bankrupt.
Return Objectives
Returns can be stated in two ways:
- Absolute Return: "I need 12% per year to fund my retirement."
- Relative Return: "I want to beat the Nifty 50 Index by 2%."
Professional IPSs often focus on Real Returns (Inflation-Adjusted). If your goal is to maintain purchasing power, and inflation is 6%, obtaining a 5% return is actually a loss of wealth.
Step 2: Defining Constraints (RRTTLLU Deep Dive)
In Module 1, we introduced the RRTTLLU framework. Now, let’s apply it to drafting the document.
Liquidity Requirements
This section lists cash needed in the near future.
Drafting Example: "The portfolio must maintain $50,000 in liquid money market funds for an upcoming house down payment due in 6 months."
Impact: High liquidity needs reduce the ability to invest in illiquid assets like Real Estate or Private Equity.
Time Horizon
This is often split into stages.
Drafting Example: "Stage 1: Accumulation (20 years until retirement). Stage 2: Distribution (Post-retirement)."
Impact: Longer horizons allow for higher equity exposure because you have time to recover from bear markets.
Tax Concerns
Taxes erode wealth faster than inflation.
Drafting Example: "Realize losses where possible to offset capital gains tax (Tax Loss Harvesting). Prefer holding bonds in tax-deferred accounts."
Unique Circumstances
This covers ESG (Environmental, Social, Governance) preferences or concentrated positions.
Drafting Example: "The client works for Google and receives stock options. Therefore, the portfolio should NOT purchase additional technology stocks to avoid correlation risk."
Step 3: Strategic Asset Allocation (SAA)
Based on the Objectives and Constraints, the IPS defines the "Baseline" portfolio. It sets target weights and allowable ranges.
Example SAA Table in an IPS
- Large Cap Equity: Target 40% (Range: 35% - 45%)
- Mid/Small Cap Equity: Target 20% (Range: 15% - 25%)
- Government Bonds: Target 30% (Range: 25% - 35%)
- Gold/Commodities: Target 10% (Range: 5% - 15%)
The "Range" allows the manager some flexibility to drift as markets move before they are forced to rebalance.
The Review Process
An IPS is not a static document. It should be reviewed:
- Annually: To ensure the strategy is still valid.
- Upon Major Life Events: Marriage, divorce, birth of a child, job loss, or inheritance.
Note: The IPS should NOT be changed based on market performance. You do not change your constitution just because the market had a bad year. That defeats the purpose of the document.
Summary of Module 2
The Investment Policy Statement separates the amateur from the professional. It forces you to address your conflicting desires (high return vs. low risk) on paper before the stress of real trading begins. It explicitly defines your risk ability vs. willingness and sets the boundaries for what your portfolio can and cannot do.
In the next module, we will take the rules defined in our IPS and start building the engine: Asset Allocation.