What Is An IPS? It’s Your Virtual “Bill Of Rights.” (Part 2 of 2)

Posted on: August 14th, 2014 by Gary Hager

compass direction(In part 1, we introduced the IPS as something that far too many investors don’t pay attention to and began discussing why it’s important to you as an investor.   In this final episode of the series, we’ll further define it and tell you what it should contain.)

An IPS has been made use of by the country’s wealthiest families for many decades.  It’s the specific “instruction manual” that makes the affluent less concerned about misdeeds by the money managers as they have a “play book” that better be followed.

Every investor should have their own personal IPS, whether they have $1,000 or many millions.  It’s practical, relatively simple and yet one person in one hundred has any knowledge that such a document even exists. It protects the firm as well as the client.  Who wouldn’t want to have a crystal clear picture of a client’s hopes, dreams and constraints laid bare to ensure their representatives can invest in accordance with their wishes?

What exactly is in an IPS?   Well, its much less intimidating than a Last Will and Testament, but probably no less important.

An IPS needs to be very specific in a number of areas. First and foremost it should have an accurate description of the client.  What he does for a living, current and expected earnings, current expenses, any health concerns for themselves or their family, both parents and children. Next and probably more important than the above is a clear statement of risk tolerance.    The volatility and maximum risk a client will take on a single investment, a single security and the total portfolio must be accurately explained.   The “ability” to take risk versus the “willingness” to assume that risk must be distinguished.

For example,  lets discuss a sample investor.   A 78 year old widow has $10MM in municipal bonds producing $450,000 in annual income. She has stated that she needs $85,000 annually to support her lifestyle.   An observation would be that she has the “ability” to take much greater risk given the great disparity between actual cash flow needs and her assets ability to produce that cash flow.  However, her “willingness” to take risk is virtually non existent.  Through the interview process we found that she grew up during the depression and saw her parents lose the family business and declare bankruptcy.  She saw her life change so dramatically that she remains to this day, worried that the same thing could happen to her.   Her IPS in response indicates her ability to take risk as high, but her willingness to take risk as very low.   This portion of the IPS provides the advisor with a clear picture of what not to do, i.e. what investments or approaches that should be avoided.

The document also needs to be clear about the level of knowledge the investor has in the variety of investment arenas from stocks through futures. For example, have they ever invested in futures, or hedge funds, international bonds or CD’s?  Just because an investor has never invested in something is not an automatic elimination of that investment approach, it does create the need to more carefully examine the use of such investment and requires a more thorough explanation of the risk and rewards of adding said investment to the existing allocation.

An IPS should contain a discussion on the best and worst experiences in their investment life and what response they had to each. Did they weather the 2007-2008 market downturn in stride or were they white knuckling and thinking about selling and never looking back? This is documented to form a more elaborate understanding of how an investor responds to both the good and the bad that all investments contain.

An IPS will go into an in depth discussion on the current portfolio (assuming it exists). The IPS should measure the expected volatility or standard deviation and risk adjusted returns.

Once the existing portfolio is mapped, the IPS will explain in detail what if anything should be adjusted or added. For instance we find that the majority of investors do not have or even understand the relevance of alternative or non correlated investments.

A truly balanced portfolio cannot be achieved without the integration of from 5% to as much as 40% of investments in alternative asset classes.

The use of alternative assets is the next step in the evolution of a properly allocated portfolio. A great example, consider a baseball team. A team sport which requires 9 position players. Most individuals with a traditional portfolio are playing exclusively with an infield. In most years the opposition is hitting ground balls to the infield. As a team we can defend that well and wind up with a productive season.

As “traditional” investors we assume we have covered the only necessary positions on field. In years when the major indices are in a decline the “opposition” was hitting balls to the outfield. Remember, we are only playing with infielders or “traditional” investments. When things are going south as it were, most people assume “Well, I guess there’s nothing I can do about this I’ll have to wait until the opposition starts hitting ground balls again.

The “outfielders” are your alternative managers.

The alternative investment is structured to have a negative or zero correlation to the more traditional investments in stocks, bonds and mutual funds.

Someone once told me if you knew someone that was a regular winner at “hold em” poker, investing in him, not the game itself can be considered an alternative investment. His performance at the tables are not relative to anything market driven, not economic conditions or anything other than his skill and luck.

Of course the alternative investment environment does not have successful poker players as an option, at least not yet, but I relate it to you to make a point. Alternative investments can be in so many areas. From Real Estate to Commodities, from Hedge fund of funds to Oil and Gas partnerships. There are too many to list in this article, but rest assured this non correlated marketplace is huge and offers the typical investor with an opportunity to reduce risk and stabilize returns in almost all market conditions. Always remember, there is no perfect investment. But we submit to you an almost perfect portfolio is obtainable.

Finally an IPS should contain an affirmation. In fact, this is the lynch pin of a properly drafted document. What good would a will or tax return be without a signature? The affirmation should state that this is a clear understanding of who you are and what you are about. It should be signed and dated by you and any person that is helping you manage your money. They should read, agree to, and sign a copy. If they can’t or won’t sign it may be time to find another advisor. After all, why wouldn’t someone want to agree to “know their client” as intimately as possible?

Time for a history lesson. There was a gentleman from the Midwest who worked in a factory his entire life, never made more than $40,000 in a given year, lived comfortably, and enjoyed fishing on the weekends. After working for approximately 40 years, he was able to save almost $700,000 in his retirement plan. While he was at work, he had the guidance of the plan administrators and fiduciaries to assist him in allocating his assets appropriately given his long-term goals.

When he retired, it was recommended to him, as he knew no one and had no interest in this area, that he work with a broker from a large, well known brokerage firm. So Mr. Smith as we’ll call him, invested all of his money with this gentleman. Before investing, he had to fill out the routine brokerage forms. As mentioned previously this form required the routine requirements of name, address, and various other  information but also asked some important questions such as whether or not you are a conservative, moderate, or aggressive investor, how much money do you have and the like. Then he had to do something which everyone that opens an investment account in the United States has to do today, and that is sign the arbitration agreement.

Arbitration is typically run by a panel of three people. Normally one or more is an attorney and at least one comes from the business community. This panel is run by people that know a lot more about the “investment game” than the typical investor.

The story continues that this gentleman retired and went off to fish. Six months later he was back at work. Why, you ask? Because the broker proceeded to blow out, or otherwise lose, almost 80% of the investable dollars by investing in high risk technology stocks at the wrong time. Bought high and sold low, a known recipe for disaster.

To most people this was as clear a case of malfeasance as there ever was.

So what happened?

First, the broker did not have anything to go on beyond his own discussions and what the client had written on his original application. Where was the oversight?  Where was the office manager who is supposed to monitor trading activity and losses?

The investor took the broker to arbitration and claimed he was cheated. He would never have authorized anything as aggressive as the way the broker speculated with his money.  The broker countered with the copies of the investors signed forms indicating that he was a growth investor.  To date the broker still works for the firm and the investor is back at his old job.

Every investor should have an IPS  whether large or small, young or old whether employed or retired.

This document will provide to anyone that represents the investor the missing “operating instructions”. No longer will the investor be held to only the documents he or she signed that were provided by the brokerage firm

The IPS is the investors’ way of taking the typical brokerage application and adding the most important finishing touch. This is who I am, this is what I care about and this is what you should and more importantly shouldn’t do.

For more information on Investment Policy Statements or to obtain a sample copy of ours, please feel free to email our firm at 732-510-1610 or at Stacey@iwmco.com.