ROGER MUNS

Before investing your hard-earned money, you need a written investment policy statement (IPS). It serves as the foundation upon which the portfolio will be constructed and managed over time and through bear (down) or bull (up) markets. The following case study will bring the key IPS concepts to life.

Background
Dr. John Stowe, 45, has been financially successful. In five years, his youngest child will finish her higher education. Funds are on hand for that purpose. He works very hard and plans to retire at age 65. Once retired, he and his wife will finally have time for leisurely travel. They want a secure and comfortable retirement, and they want to pass some wealth to their children (and hopefully grandchildren).

John does not have the time or interest to manage his financial assets. Instead, he will use a knowledgeable, professional investment advisor. In working with an investment advisor, his primary concerns are to (a) make sure his investment goals and objectives are understood and followed and (b) establish a clear way to evaluate the performance of the investment advisor. His investment policy statement will address both concerns.

Defining Goals and Objectives
John's ability and willingness to take risks need to be carefully explored. A very wealthy person has the ability to withstand significant volatility in the market. Regardless, this person may or may not be willing to take risks. Risk and return objectives must be compatible. Investors get paid for taking risks.
Taking only modest risk and expecting high returns does not compute.

John's investment time horizon is a very important consideration. "Longevity risk" is the risk that he and his wife will outlive their assets. The chance that at least one spouse will live to age 85 is 78 percent and to age 95 it is 31 percent.

Over a long time horizon, stocks provide the highest expected returns. While John works and brings home the bacon, he will have a balanced portfolio including a significant allocation to equities. In retirement, the allocation to stocks will decrease and bond allocation will increase.

Any significant liquidity needs must be identified, such as buying a second home or paying off a mortgage. Investments selected to fund a liquidity need will be heavily influenced by its expected time horizon. Other considerations include income taxes, legal constraints and John's desire to leave some wealth for his children. The investment advisor must carefully listen to John and prepare for John's review a draft of the proposed IPS that best fits his risk and return objectives and constraints.

Setting the Asset Allocation Policy
Research has proven that asset allocation is the determinate of 90 percent of a portfolio's returns. John's IPS will specify his asset allocation, which insures that his portfolio is properly diversified. For example, the asset allocation targets (and ranges) might look like this: Cash 0 percent (0-5 percent), stocks 70 percent (55-80 percent) and bonds 30 percent (20-40 percent).

Of the 70 percent target allocated to stocks, it will be further divided into target (and range) allocations as follows: domestic large-caps 39 percent (33-45 percent), domestic small-caps 10 percent (5-15 percent) and international 21 percent (15-27 percent). Of the 30 percent allocated to bonds, the IPS may require that only investment grade bonds be purchased and specify the average duration (maturity) and type of bonds such as municipal bonds, United States Treasury and corporate bonds, international bonds, inflation-protected bonds and/or others.

With these specifications clearly defined and understood, John can rest assured that his professional manager is equipped to follow his needs and desires. Now there must be a measure for the performance of his professional.

Benchmark
The Dow Jones Industrial Average and the S&P 500 indexes are both used to measure the performance of domestic large-cap stocks. Numerous indexes are used to track the performance of domestic small-cap stocks, international stocks, bonds and many other segments of the market.

An ideal benchmark for John's portfolio is based on two assumptions: (a) the actual and target asset allocations are identical and (b) the actual returns mirror returns of appropriate indexes. The benchmark is the summation of the target allocations times the returns of the related indexes. If the annual benchmark return is 10 percent and the actual returns are significantly lower or higher, then something is awry. The primary causes for large variances in performance are (a) actual and target asset allocations are significantly different and/or (b) returns from the actual holdings significantly vary from the appropriate indexes due to inferior or superior security selection or market timing.

Summary
In developing a clearly written IPS, you strategically consider the market expectations and your goals and objectives. Careful planning will better equip you to cope with the inevitable and unpleasant bumps in the market. The IPS will (a) help ensure that your investment goals and objectives are clearly understood and followed by your investment advisor and (b) establish a clear benchmark to evaluate


April 2007