An IPS, your ounce of prevention

One area in the field of finance that has been growing in acceptance is that of behavioural economics- sometimes referred to as behavioural finance. In essence, it deals with the various intellectual and emotional errors that nearly everyone fact seems to make. Concepts like overconfidence, negative loss aversion, mental accounting, hindsight bias and anchoring have gained considerable acceptance in the financial services industry.

It seems many of us know what we’re supposed to do when managing portfolios; we’re just lousy at actually doing some of those things. The phrase, “buy low; sell high” is a trite little truism people ignore all too often – and usually at great peril. In theory, a good advisor should help to mitigate the otherwise self-destructive tendencies that behavioural finance has unearthed.

In the institutional world, money managers have long been using a strategic document known as an Investment Policy Statement (IPS) to better manage expectations and to curtail a number of potentially self-destructive habits. Slowly, but surely, IPSs have been making their way in to the world of retail investments, too. My view is that IPSs are among the best available vehicles to bring investors back to the ‘first principles’ of their investment strategy.

In conceptual terms, one could simply think of an IPS as a “portfolio blueprint”, since it spells out the most salient elements of portfolio design and management. These include: expected rate of return, tolerance for risk, time horizon, frequency of re-balancing, portfolio objectives and, perhaps most importantly: strategic asset allocation. A number of studies have shown that asset allocation explains the lion’s share of variance in looking at how a balanced portfolio performs relative to its investment policy.

There are people out there who would have you believe that one needs to use either a wrap account or a separately managed account in order to get an IPS. That is untrue. Any qualified advisor can write an IPS as long as a consistent process of discovery is used. A more disciplined and rational decision-making thought process is likely to ensue.

Once the client has affirmed the highlights, writing a functional IPS should be a process-driven mechanic. Most are only five to ten pages long, although some IPSs cover considerably more ground for institutional clients. Some are text-heavy, while others use bullet points, charts, graphs and spreadsheets. The important thing is that salient objectives are defined and agreed upon.

The great thing about having an IPS in place is that any products (individual securities, mutual funds, exchange traded funds, etc.) can be used to gain access to the asset classes chosen. My opinion is that virtually any qualified advisor can write an IPS. As a matter of fact, one could write an IPS oneself and use it in holding oneself accountable for buy/ sell and re-balancing decisions, too. In all my years in the financial services industry, however, I have only met one do-it-yourself investor who claims to have implemented a functional IPS.

Since IPSs are essentially accountability and management documents, they protect both advisors and clients from unscrupulous activity by the other party. Because the main elements of portfolio design and management are in writing, it would be difficult for either party to deviate from the agreed approach in a material way.

A simple example would be having the IPS call for a 20% allocation in Canadian Equity with the market dropping so that Canadian equity makes up only 15% of the portfolio. If an RRSP contribution were being made, it would make sense to buy more of the asset class that is currently under weighted. Although everyone knows it is prudent to buy low and sell high, may people still have difficulty in adding to a position that has performed poorly when other portfolio components have done relatively better. This also re-enforces a ‘total portfolio’ approach and implicitly acknowledges that it is improbable that everything will be doing well at the same time. To my mind, a major factor in the role of any financial advisor is keeping clients focused on the big picture.

Some people have suggested that financial advisors are a bit like personal trainers, since they encourage people to do what they want to do and ought to do, but might not always do if left to their own devices. If that metaphor resonates with you, then you might want to think of an IPS as a kind of ‘workout regime’, since it allows for a consistent and purposeful experience that is designed specifically for the person using it. As with any program of this nature, one should be able to see and measure the results when monitoring how things are going.

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.