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Investment policy statement: Explained

BY TIO Staff

|July 29, 2024

In the world of trading, an investment policy statement (IPS) serves as a strategic guide to the planning and implementation of an investment portfolio. This document, often overlooked by novice traders, is a critical tool for setting clear expectations, defining investment objectives, and establishing a framework for future decision-making. It's a roadmap that helps to align the investor's financial goals with their risk tolerance, investment horizon, and other personal circumstances.

The IPS is not a static document, but rather a dynamic one that evolves with the investor's changing needs, market conditions, and investment knowledge. It's a living document that should be reviewed and revised periodically to ensure it remains relevant and effective. In this comprehensive glossary entry, we will delve into the intricate details of an investment policy statement, its importance in trading, and how to create one.

Understanding the Investment Policy Statement

An investment policy statement is a written document that outlines an investor's investment objectives and strategies. It provides a framework for managing the portfolio over the long term, taking into account the investor's risk tolerance, time horizon, and financial goals. The IPS serves as a guide for making consistent, well-thought-out investment decisions, even during periods of market volatility.

The IPS is not a guarantee of investment success, but rather a tool to help investors stay focused on their long-term goals and avoid making impulsive decisions based on short-term market fluctuations. It helps to reduce the emotional component of investing, which can often lead to poor investment decisions.

Components of an Investment Policy Statement

An IPS typically includes several key components. The first is the statement of objectives, which outlines the investor's financial goals and how the portfolio will be managed to achieve them. This could include details about the desired rate of return, the acceptable level of risk, and the time horizon for achieving the goals.

The second component is the statement of strategy, which describes the investment strategies that will be used to achieve the objectives. This could include details about the types of investments that will be included in the portfolio, the asset allocation strategy, and the criteria for selecting and monitoring investments.

Importance of an Investment Policy Statement

An IPS is important for several reasons. First, it provides a clear and consistent framework for managing the portfolio, which can help to reduce the likelihood of making impulsive or emotional investment decisions. Second, it helps to ensure that the investor's financial goals and risk tolerance are clearly understood and taken into account in the management of the portfolio.

Third, it provides a benchmark for evaluating the performance of the portfolio and the effectiveness of the investment strategy. By comparing the actual performance of the portfolio with the objectives and strategies outlined in the IPS, the investor can determine whether the portfolio is on track to achieve its goals and whether any adjustments are needed.

Creating an Investment Policy Statement

Creating an IPS involves several steps. The first step is to define the investor's financial goals. These could include saving for retirement, funding a child's education, buying a home, or building a nest egg for future needs. The goals should be specific, measurable, achievable, relevant, and time-bound (SMART).

The second step is to determine the investor's risk tolerance. This involves assessing the investor's ability to withstand losses in the value of the portfolio without panicking or making impulsive decisions. Factors that can affect risk tolerance include the investor's age, financial situation, investment knowledge, and personality.

Asset Allocation Strategy

The third step in creating an IPS is to define the asset allocation strategy. This involves deciding how the portfolio will be divided among different types of investments, such as stocks, bonds, and cash. The asset allocation strategy should reflect the investor's risk tolerance and financial goals.

For example, a young investor with a high risk tolerance and a long-term goal of building wealth might have a portfolio with a high percentage of stocks, while an older investor with a low risk tolerance and a short-term goal of preserving capital might have a portfolio with a high percentage of bonds and cash.

Investment Selection Criteria

The fourth step in creating an IPS is to define the investment selection criteria. This involves deciding what types of investments will be included in the portfolio and how they will be selected. The criteria could include factors such as the performance history of the investment, the reputation of the management team, the fees and expenses associated with the investment, and the investment's fit with the overall asset allocation strategy.

The investment selection criteria should be clearly defined and consistently applied to ensure that the portfolio is managed in a disciplined and systematic manner.

Implementing the Investment Policy Statement

Once the IPS has been created, the next step is to implement it. This involves selecting the specific investments that will be included in the portfolio, based on the investment selection criteria defined in the IPS. The investor should also establish a system for monitoring the performance of the portfolio and making adjustments as needed.

The implementation of the IPS should be consistent with the investor's risk tolerance and financial goals. It's important to remember that the IPS is not a set-it-and-forget-it document, but rather a guide that should be reviewed and updated periodically to reflect changes in the investor's circumstances or market conditions.

Monitoring and Rebalancing

Monitoring the portfolio involves regularly reviewing the performance of the investments and comparing them with the objectives and strategies outlined in the IPS. If the performance of the portfolio is not in line with the IPS, the investor may need to make adjustments. This could involve selling investments that are not performing well or buying more of investments that are performing well.

Rebalancing the portfolio involves adjusting the asset allocation to keep it in line with the strategy defined in the IPS. This could involve selling some investments and buying others to maintain the desired balance of stocks, bonds, and cash. Rebalancing can help to manage risk and ensure that the portfolio remains aligned with the investor's financial goals and risk tolerance.

Conclusion

In conclusion, an investment policy statement is a critical tool for managing an investment portfolio. It provides a clear and consistent framework for making investment decisions, helps to align the investor's financial goals with their risk tolerance and investment horizon, and provides a benchmark for evaluating the performance of the portfolio.

Creating and implementing an IPS requires careful thought and planning, but the effort can pay off in the form of a more disciplined and effective approach to investing. Whether you're a novice trader or a seasoned pro, an IPS can help you stay focused on your long-term goals and navigate the ups and downs of the market with confidence.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.

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