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Set out the parts that make up an investment policy statement

CFA® Level I · Portfolio Construction · Basics of Portfolio Planning and Construction · PM.3.a

The idea

An investment policy statement writes down what the portfolio is for before anyone starts managing it. It sets objectives - return requirement and risk tolerance, which have to be reconciled rather than stated separately - and constraints, conventionally liquidity, time horizon, tax, legal and regulatory position, and any unique circumstances. Risk tolerance itself has two parts that are often confused: the ability to bear loss, which is a matter of horizon and wealth, and the willingness to, which is temperament. Where they conflict, the lower of the two governs. The statement's real function is to be read during a drawdown, when the decision it records was made calmly and the one being contemplated is not.

A practice question

From the question bank, with the reason each wrong option is wrong.

An investment policy statement sets out a portfolio's objectives and its:

  1. constraints - correct
  2. past performanceWhy not: Past performance is a result, not a policy input. The statement lists what the investor wants and what limits the portfolio.
  3. manager selection criteriaWhy not: Choosing managers comes later, once the objectives and constraints are set.

An investment policy statement is a written plan agreed before any investing starts. It says what the investor wants, which are the objectives (for example growth or income, and how much risk is acceptable). It also says what limits apply, which are the constraints (for example how soon the money is needed, tax position, and any rules or personal preferences). There is no formula here. The idea is: objectives = what is wanted, constraints = what is allowed. Daily trades and tax returns are records made afterwards, not part of the plan.

A harder one

Willingness to bear risk differs from ability in that willingness is:

  1. objective and measurableWhy not: Willingness is subjective. It is a matter of attitude that cannot be read from a balance sheet.
  2. a matter of temperament - correct
  3. determined by the investor's net worthWhy not: Net worth bears on ability to take risk. Willingness is about attitude and can differ widely between equally wealthy people.

Risk tolerance has two halves. Ability is about facts: can the investor afford losses, given wealth, time and goals? Willingness is about feelings: how comfortable the investor is with seeing the portfolio fall. This is a matter of personality, so two people with identical finances can feel very differently. Regulation can limit what may be held, but it does not describe how someone feels about risk. No formula applies; willingness = temperament, ability = circumstances.

The hardest tier

Stating a return requirement without reference to risk tolerance produces a policy that is:

  1. complete, since the return target defines the policyWhy not: A return target alone says nothing about how much risk the investor can take. The two must be set together.
  2. incomplete, since return and risk must be reconciled - correct
  3. acceptable, since risk can be addressed after investingWhy not: Risk has to be set before investing, because the return needed may require more risk than the investor can accept.

Any return can be targeted if risk is ignored, because higher returns generally mean taking more risk. So a return goal on its own is only half of the plan. The investor must also say how much risk they can accept, and then the two must be matched. If the return needed requires more risk than the investor can bear, the goal must change. The rule: return requirement and risk tolerance must be set together and reconciled. A goal with no risk limit is, if anything, aggressive, not conservative. No formula applies.

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