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Set out the parts that make up an investment policy statement

CFA® Level I · Portfolio Management · 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. daily tradesWhy not: A record of transactions, produced after the fact. The policy statement is written in advance and governs what may be done.
  3. tax returnsWhy not: A filing obligation. Tax appears in the statement as a constraint, but the returns themselves are not part of it.

Objectives say what is wanted and constraints say what is permitted, and both are needed before any asset is bought.

A harder one

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

  1. objective and measurableWhy not: That describes ability, which follows from wealth, horizon and the importance of the goal.
  2. a matter of temperament — correct
  3. set by regulationWhy not: Regulation can constrain what may be held; it has nothing to say about an investor's disposition toward risk.

Two investors with identical finances can have quite different appetites for watching a portfolio fall.

The hardest tier

The main practical value of an investment policy statement is that it:

  1. guarantees the return target is metWhy not: No document can guarantee a return. It records what will be attempted and under what constraints.
  2. eliminates market riskWhy not: Market risk is borne deliberately in pursuit of the return objective; the statement says how much of it is acceptable.
  3. records a decision made calmly, to be read when conditions are not — correct

Its function is to be consulted in a drawdown, when judgement is worst and the temptation to abandon the plan is highest.

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