Business

Wednesday October 7, 2009

Why we need an investment policy statement

Personal Investing - Ooi Kok Hwa


WHEN we invest, we may engage the services of an investment advisory. One of the most important documents that we need to establish together with the investment advisor is an investment policy statement (IPS).

It is a formal document that provides all the guidelines as well as disciplines for our portfolio investment decision making.

Why we need an IPS?

Most of us are highly influenced by our emotions when we invest. We tend to shift our investment strategies during a bull or a bear market where we may become too bearish when the market drops to a very low level or too bullish when the market surges to a very high level.

The presence of an IPS will provide the long-term discipline and guidelines so that we will not stray too far from our original investment objectives regardless of the market situations.

What are the key elements in an IPS?

Every IPS must first describe the investor’s current situation which includes his financial status and requirements.

For example, it will list the number of people in his family, their ages and current health situations; sources and size of current income and expenses; his current net worth minus all the liabilities; his occupation; size of funds available for investment; size of other assets; his temperament training as well as experience in investments.

The IPS will then explain its purpose with respect to policies, objectives, restrictions and limitations. It will list all his responsibilities as well as the responsibilities of the investment advisor involved.

This will help both parties understand their roles in managing the investment portfolio.

The next section, which is also the most important, describes the investment objectives and investment constraints of the investment portfolio.

Investment objectives comprise two key areas: the required rate of returns and risk tolerance level of the investor.

The required rate of return is related to the level of return that must be obtained by the portfolio to meet the financial objectives and financial obligations. It is associated to meeting the portfolio long-term financial objectives, like early retirement and achieving financial freedom.

An investor’s risk tolerance level can be divided into his ability and willingness to take risk. The ability to take risk will look into the investor’s current financial conditions, which include any financial need in the short term and ability to recover from any investment losses incurred.

To assess the ability to take risk, the investment advisor has to take into consideration the investor’s total net worth, the time horizon that he intends to invest as well as the liquidity needs; while his willingness to take risk will be related to his psychological profile and past experiences in dealing with investment. Sometimes, even though the investor may have a big fund size, due to his previous bad experiences in investing, he may not be willing to take risk.

Investment constraints will explain all factors that may limit the portfolio investment choices. There are five classes of constraints – liquidity, time horizon, legal and regulatory concerns, tax considerations and unique circumstances.

Liquidity constraint will explain the regular expenses as well as any potential major spending in the next few months.

Time horizon is related to time periods involved from now until the investor’s major life events, such as to become debt free or achieve financial freedom.

In general, an investor’s time horizon can be divided into pre-retirement and post-retirement periods.

Legal and regulatory factor will specify types of investment classes that are not allowed, which normally affect institutional investors. Tax considerations deal with taxes on capital gains and dividend income. In Malaysia, since we are not subject to capital gains tax, those high tax-bracket investors may prefer capital gains rather than dividend incomes.

Lastly, unique circumstances will explain any extraordinary expenditures, conditions and inconsistencies which can affect the investor but are not stated in any part of the portfolio planning. For example, some Muslim investors may prefer only investing in halal companies.

After considering the investment objectives and all the investment constraints, the investment advisor will advise the investor on the appropriate asset allocation and security selections in view of the current market situation.

In addition, it should also state a calendar of review meetings for portfolio rebalancing and performance review.

In short, one of the most important objectives of an IPS is to provide the long-term discipline in managing our investment portfolio. With an IPS, we will be able to achieve our investment objectives in a more systematic way.

l Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

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