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Why is Investment Policy important?


Isn’t it odd that Institutional investors, like pension funds, are legally required to put a plan in place to discharge its liabilities (ie. Its future retirement / benefit payments to pension plan members). But in the Individual investor’s world, the best one can expect is a Know Your Client or KYC form. (Is this a tool for the investor … or for the Advisor)? Individuals, I think, should either deal with an Investment Counsellor (who use an Investment Policy) or demand an Investment Policy document from their Advisor.

Why? Many reasons. Here are four.

First, it’s the ‘job description’ between the investor and the advisor. It’s clear and in writing what has to be done, by whom, when and how. Fewer surprises.

Second, it provides both investor and advisor an agenda to return to when market hell breaks loose. It helps prevent a 180 degree turn in strategy because of emotions (a bad day, something you read or something a guy at the office said). No panic. No knee jerk reaction. Investment Policy is a Plan. It documents where you are trying to get to. But along the way, if this happens, we will do x. If that happens we will do y.

Third, it outlines Asset allocation. Regardless of one’s investment strategy or service provider, asset allocation is the single most important investment decision any investor must make. (And the least understood). Asset allocation, more than any other investment decision, determines investor outcomes.

Asset allocation is the spreading of monies toward assets that are most appropriate to achieve investor objectives but are within their parameters. (Ideally documented in the Investment Policy). Asset allocation ensures broad (or narrow) exposure to economic growth opportunities globally (or not) depending on the investor-specific requirements (or sometimes depending on the ‘need for speed’). Usually, there are ranges (hi-to-low tolerances) for each asset class. By managing within ranges, there are fewer wild swings in portfolio ‘bets’ and more stable value. Good portfolio management makes only incremental adjustments (not sweeping changes) that reduce or increase exposures and ensure the portfolio progresses toward client objectives. It’s more like steering and less like changing directions. With fewer wild swings in allocation, make an investor’s portfolio more predictable.

We’ve known about asset allocation for more than 60 years. It works. (Despite what you may be reading to the contrary).

Fourth, is separation of emotion from logic. It is critical that Individual investors recognize that capacity for risk does not equal tolerance for volatility. This is best said by Richard Ennis, Editor of the Financial Analysts Journal.

Investment thinking today appears to be heavily influenced by want.

Successful investment requires more than motivation. It also requires direction and control which are the functions of investment policy. Investors motivated by want but lacking a well-thought-out investment policy can find themselves, in fact, incurring more risk or illiquidity than suits them.

Investment policy has three dimension, all grounded in investor capacity – not want, preference, or ambition. One is the capacity to bear risk. The second is the capacity to hold illiquid assets. The third is the capacity to exploit security mispricing. Investment policy also must be shaped by market realities and, in particular, by logical return expectations.

Investors with little or no tolerance for risk typically earn a return not unlike the rate of inflation. Those that can live with stock market volatility can expect … a greater return.

(For a good Investment Policy read, I recommend Charlie Ellis classic book, “Winning the Losers Game”).

Again, the comprehensive planning work is the ‘why’. The Investment planning or policy is the ‘how’ and within what constraints, parameters or guidelines. The Investment policy will become the single most important planning document for any investor. One way to understand the importance of the Investment policy document is to examine the components. (We will).

Planning is a process because changes in ones objectives cause a re-start from the top-down. ‘Life events’ such as births, marriages, divorces, deaths, inheritances etc. drive change in an Individual investor’s requirements. New requirements drive any strategy. Again, that strategy must eventually revolve around asset allocation. Market volatility does not drive strategy nor should it change investor-specific asset allocation. If this were the case, investors would be changing their asset mix several times each day. And what would be the point of planning?

Too much of the Individual investor’s time and money management budget is devoted to buying products. Too little is spent planning. The beauty of planning is that it’s controllable. Markets are not.

Next time?

Planning is easier than you think. Planning tools & resources.

Doug Cronk, CFA is Manager, Investments for a Canadian Pension fund.

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