At the outset of any portfolio management process, an investor must make a number of important decisions – with or without the help of an investment advisor. What are their investment return objectives? What are their financial constraints? Typically, this information is gathered into a document called an “investment policy statement”. What is usually included in this statement and why is it so important?
First, return objectives should be clearly specified to allow for the proper selection of assets. Second, the return goal should be clearly measurable and achievable. For example, “earn enough for early retirement" is not a measurable return objective since the precise yield is not clearly indicated. “Earn on average 2% above the Consumer Price Index (CPI) in the United States” is a much better example since it gives an exact understanding of the target return.
After the return objective has been defined, the risk tolerance should be assessed. In general, because risk and return are positively correlated, the investor should be open to assuming more risk to achieve superior returns (as indicated in our sample return objective). Risk-free assets (e.g., Treasury bills or insured bank deposits) will most likely yield returns close to or even below the inflation rate. The risk tolerance limits the volume of risk the investor can assume given his or her unique circumstances, and consists of several important components.
First of all, liquidity constraints should be taken into account (from here on we will be referring to a hypothetical example of a 40-year old investor who has $200,000 in savings and contributes an additional $50,000 annually). Our investor is unlucky enough to have some health problems, which potentially may lead to medical expenses of up to $50,000 in the next year, but the probability of this is uncertain. Since this amount is significant in relation to his total portfolio (25% of total funds) and the importance of the expense is high (in other words, it cannot be postponed), an appropriate share of investments should be made in assets with sufficient liquidity and low price volatility. Should this share of the portfolio need to be liquidated quickly, it will only sustain limited losses due to a potential short-term price decline. Penalties for early redemption of the financial asset (for example, with life insurance products) should also be considered here, however.
Second, it is essential to specify a time horizon for investments. Typically, it should also be aligned with anticipated large spending so that the exit from particular investments is planned in advance. The difference between this and liquidity constraints is that such expenditures are more or less known in advance, so the amount required to fund them can be invested in more long-term assets. A good example of such spending could be a down payment on a real estate purchase or tuition fees for children. Unplanned liquidations introduce additional price risk and may lead to losses.
Last but not least, the earnings capacity, or the investor’s ability to recover after any potential losses, should also be taken into account. Most investors earn money from regular income sources such as salaries or rental income. Therefore, if losses arise from unsuccessful investments, the investor must be able to quickly increase their capital. The earnings capacity is also affected by life circumstances such as retirement, a time when an investor generally does not have the ability to contribute to his or her portfolio anymore and needs to withdraw funds for living expenses instead.
The longer the time horizon (e.g., the younger the investor is, in most cases), the more tolerant he or she is towards any investment losses, and the riskier the assets that may be included in the portfolio. Suppose our sample investor has an above-average earnings capacity since he has been employed for 15 years and his comparatively large contributions indicate a healthy income.
To sum up, it is readily apparent that different return objectives and personal risk characteristics may lead to dramatically different investment portfolio strategies. That is why an investment recommendation generally should only be taken into account with a well through-out portfolio management strategy and an adherence to the investment policy statement.