Building plan keeps investors on track

Imagine building a house without a set of plans.  How would that house look if you randomly selected flooring, furniture and window coverings without regard to how they would look together?  It certainly can be done, but we all know that when building or decorating a home, it is best to follow a plan.  Once a plan is put in place, the results can be spectacular!

Too often investors select investments without consideration given to the other investments within their portfolio.  Does purchasing that one additional investment increase or reduce the risk to the investment portfolio?  Does it increase the return potential or reduce it?  Does it compliment the other investments?

The financial equivalent to a blueprint for building a home is an Investment Policy Statement (IPS).  Ideally an IPS should be laid out in advance of the portfolio’s construction, however, an IPS can be done at any time – call it a renovation if done after the fact.  Developing an IPS normally begins with the investment advisor asking their client to answer a series of questions.  The investment advisor should review the answers to these questions with the investor and clarify any inconsistencies.  The responses to these questions, along with notes made during preliminary discussions, are the foundation to an IPS.

An IPS is part of a disciplined approach that attempts to remove some of the “emotional component” of investing.  Uncertainty about the markets, fear of losing your money, and confusion as to what is the best course of action during volatile market times can cause investors to abandon the plan.  Sticking to the IPS during difficult times is a critical part.  As we all know, we cannot individually control the market, however, we can control how we react to it. An IPS can help manage those bumpy times.

An important component of those discussions should focus on risk tolerance.  The easiest way to look at risk tolerance is by the percentage of equities in the account.  An investor who is risk averse would have a lower percentage of equities.   Investors that do not want to incur risk should have a larger component of investments such as GICs, treasury bills, and investment grade bonds (often referred to as fixed income).   As fixed income investments are not as volatile as equities, they are a key component for those seeking low risk investments and have capital preservation as a primary investment objective.  Most investors desire total returns greater than those currently offered by fixed income.  As a result, risk tolerant investors are willing to hold some component of equities.

As every investor reacts differently to volatility, it is finding that balance (also known as Asset Mix) that the investor is comfortable with.  Investors that do not assume some risk may feel they are missing out on potential opportunities, and investors that feel they are taking on too much risk may be continually worrying about their investments.

So, what are the typical characteristics of the risk-tolerant and risk-averse investor?  Typical characteristics of risk-tolerant investors are:  longer time horizon, high annual income, high net-worth, and multiple sources of income.   The typical investor who is risk-averse, would have the following characteristics:  shorter time horizon, no longer in the work force/approaching retirement, fixed income, low to moderate net-worth, and limited sources of income.

The above general rules certainly do not apply to everyone, this is the reason a customized IPS is necessary for each investor.  The most risk-tolerant investor may intentionally overweight equities while the most risk-averse investor may deliberately select mainly fixed income.  However, most investors fall somewhere in between.

Determining the balance of cash, fixed income and equities is ultimately the decision of the investor.  An advisor has several tools in which to assist their client in making this decision.  An IPS is not set in stone – changes may occur with time, life changing events and investment experience.  Some advisors may recommend increasing or decreasing the fixed income component during certain economic cycles.

One rule of thumb that is used by some investment advisors is that the fixed income component should be reflective of your age.  A 20 year-old investor should have 20% fixed income where an 80 year-old investor should have 80% fixed income.   This method of determining the asset mix is overly simplistic but it does illustrate the trend of having a larger fixed income component as an investor gets older.

As it takes time to build a house, it takes time and patience to build an investment portfolio.  Once built it still requires maintenance.  The IPS is a plan, not an immediate reflection of how the portfolio will look on day one.

After reading this article, we hope investors will try to locate their written Investment Policy Statement.  If they have one, they should ensure they are using it and that it is up to date.  If they do not have one then statistics state they are among the majority of investors without a plan.  We also hope those investors without an IPS will meet with their investment advisor to discuss the benefits of an Investment Policy Statement.