What Is An IPS? It’s Your Virtual “Bill Of Rights.” (Part 1 of 2)

Posted on: June 12th, 2014 by Gary Hager

financial investingMost investors don’t have the vaguest idea of what it means to have an Investment Policy Statement (IPS).  In fact most investors when asked don’t even know what it is.  An IPS is an investors virtual “bill of rights”.   A document that provides a clear and concise summary of “who” the investor is.   A properly prepared IPS presents the “whole” client.   It states very important items, like risk tolerance, time horizon, and needs for cash flow.   It also provides additional subjective data such as information on the clients investment experience, work history and many other items that add up to a working manual.  Every investor, small or large needs an IPS and this two-part series will explain in detail what you need to know.

EPISODE I:

Since March 2009 we have had incredible upward momentum in the equity markets. Lately, many people are asking the question, “Where do we go from here?”

Where should I invest now?  Should I change course, or keep the current allocation?  What markets will lead, which will lag?   If you are like many people, you don’t even think about it because your broker or advisor is supposed to be doing that for you.

How do you know if the advisor you have has your best interests at heart?   How do you know if he or she is watching as closely as they say?

Are they watching for style drift, or countless other signs that a stock, mutual fund or separately managed portfolio is in need of attention?

Most importantly has the advisor asked all the necessary questions, not the required questions on a brokerage form, but the true thought provoking questions that lead to real understanding?   How does the investor truly protect him or herself, making sure that their portfolio design matches their expectation? In order to determine the best way to go about this it pays to begin with a little history.

As you grew up you received money from a variety of events, birthdays, communions, bar and bat mitzvahs and if your parents advised you correctly that money (or most of it) finds its way into a saving account at the local bank.  At some point you may have moved that money into more aggressive investments which can include everything from money market to stocks and mutual funds.

You got older, made it through school, got a job.  You learned or were told by someone (your parents, friends, business associates) the way to grow your assets more effectively by investing in things other than a statement savings account at the local bank.   Maybe you were coached to buy a “hot” stock or mutual fund.  Of course there were pitfalls to be sure (see the crash of 2008), but you have likely been bombarded with the many talking heads and investment publications discussing the vast wealth created in the stock market.  But most of these talking heads were telling an incomplete story.

Over time, either through your company’s fiduciaries or by a friend telling you success stories about certain stocks (or perhaps a cold call), you found someone that was going to lead you to investing nirvana.

You invested and maybe you did well.  You had off years and great years and became comfortable with your relationships.  And things went on well forever and you became rich and famous.

But maybe you weren’t one of the few who turned $10,000 into $1,000,000.  People from the ultra affluent to the local garage mechanic have found that everyone who had the opportunity to exit a position before the worst occurred, rarely did.  People rode these and many other stocks into the ground.

Congratulations, you represent 1/30th of 1 % of the investing public.  The reality is most people view the “markets” beyond the money markets as a mystery.  An enigma wrapped in a riddle.   What exactly is a SPIDER and why should I invest in it?  And why do they call it something that scared me when I was 12 in sleep away camp?

There is lots of data today, available from so many sources, Jim Cramer, CNBC, WSJ, Barrons, IBD, just to name a few, oh yes, lets not forget the loads of advice on the web.   Friends, brokers, TV…what’s a rational and sometimes sane person to do?

Let’s see if you are like 1/10 of 1 % of the investing public by answering the following questions:

What is the expected risk adjusted performance for your portfolio?

Don’t know?  Don’t be shocked, most people don’t know the expected return of any investment they are in let alone the risk adjusted return.

What benchmarks and peer groups are being used to assess comparative performance?  There are many benchmarks such as the S&P500 and the NASDAQ, and many blended benchmarks as well. The only way to assess individual stock and fund performance is through the proper use of comparative benchmarks and peer group comparisons.

How about a few more simple questions:

What was your total return for last year, after fees, commissions and expenses?

Oh, yes and what exactly was your all in cost for your portfolio?  Not sure?   Join the club.    Why do you think you see ads on TV with investors bemoaning the diversity of charges from their brokerage firm.

All of this build up leads us to the crux of this article and the purpose behind having a document in place that becomes an investors “bill of rights.”   This document is referred to as an Investment Policy Statement or IPS for short.   But still, a little more background is needed.

OK, so you’ve decided to invest, and not just under your mattress anymore, you have looked around and have seen the gazillions being made all around you and said “I want in!”

Most investors start “serious” investing at a brokerage firm. It can be a discount broker like an E-Trade, or TD Waterhouse or it can be (need on line agreements) a full service wire house like a Merrill Lynch, or UBS.    When opening an account, you have numerous decisions to make as an investor.

In all instances, you need to fill out a pretty standard account form.  This form asks mostly rudimentary questions such as name and address, etc.   It also will ask questions about account title, net worth, liquid net worth, income and investment objectives.    Many forms will now ask for additional data such as source of funds, and experience in a variety of markets, (commodities, bonds, options, stocks, to name a few).

Here’s the problem:  In no way does the investment firm have to check the accuracy of the entries.   As the industry is hungry for money under management it’s all about “getting” the account.   Most times a true in depth interview never occurs or if it does, it is not documented.

The brokerage firm does require that before they will open the account, the customer must sign an agreement to arbitration.  This portion of the account application is designed to provide a simple forum to resolve disputes that may arise from a variety of events.  What events?   Loss of principal, style drift, improperly authorized trading, excess charges, churning again, to name just a few.

What if the worst happens?

You lose all or most of your money through mistakes, misdeeds or outright ignorance and stupidity.  You picked a broker who followed his path, not yours.  All industries have their “bad guys”.  Lawyers, Doctors, Insurance, Contractors, etc.  They may only care about themselves and their next commission.  So what can you do if you find you are on the short end of the stick and the broker says,” Hey, don’t worry, it’ll come back, or “you authorized me to do that” or a hundred other things he might say when (to quote Max Liebkind in The Producers), “Boy, when things go wrong”.

This article is not meant to argue the pro’s and cons of the arbitration system.  Arbitration was devised to protect the investor from having to potentially shell out big bucks to sue a firm that had much deeper pockets than they do.  Bottom line, the system favors the broker, not the investor.

How can investors better protect themselves?

One answer beyond being born under the right star is to draft an Investment Policy Statement.   This is a document that is created for the investor before any investments are made and goes deeply into the investors skills (or lack of), goals both short and long term, risk tolerance, time horizons, needs for cash flow, and tax sensitivities to name just a few.

It discusses actions to be taken in the event of death, disability and projected retirement.  It is a very broad document, and covers the dots on the “twister” board well but it is a working blueprint and based on ongoing events, should be updated.  We always suggest an annual review, like a well visit to the physician in order to ensure that it continues to speak about who and what you are about. It should be provided to anyone that custodies assets for you and should be signed by both parties.

Would you build a home without architectural plans? Would you shoot first and take aim later?  Yet most people who hear Jim Cramer screaming about some tech stock he loves will plunk 10,000 down like a pass line bet at the Mirage expecting nothing but a 4 and 3  to appear on the dice.  And what happens when craps appear?  Cramer, wrong?   Impossible.  What if you could protect yourself from yourself, the media, the brokers and oh yes the lawyers?

In our final installment of this series, I’ll answer that “What if” and further clear up the picture of what an IPS is and why you need one.