/investment-policy

name: investment-policy
description: "Construct comprehensive Investment Policy Statements governing return objectives, risk tolerance, and portfolio constraints. Use when the user asks about building an IPS, setting return objectives, assessing risk tolerance, defining investment constraints, or establishing rebalancing and benchmark policies. Also trigger when users mention 'investment plan', 'policy portfolio', 'risk capacity vs willingness', 'spending rate for an endowment', 'foundation payout', 'manager selection criteria', or ask how to document their investment strategy."

Investment Policy Statement Construction

Core Concepts

Investment Policy Statement (IPS)

The IPS is the governing document for all investment decisions. It specifies objectives (return and risk), constraints, asset allocation ranges, rebalancing policy, benchmark selection, and review schedule. Every portfolio action should be traceable back to IPS provisions.

Return Objective

The required return is the rate that funds all future liabilities and goals.

• **Required return:** Solve for the discount rate that equates the present value of assets to the present value of future liabilities/spending needs.
• **Spending rate (endowments/foundations):** Typically set as a percentage of a rolling average of portfolio value (e.g., 5% of 3-year rolling average AUM). The required nominal return must cover spending + inflation + fees.
• Required nominal return = spending rate + expected inflation + investment management fees

Risk Tolerance

Risk tolerance has two dimensions that must be assessed independently:

• **Ability (financial capacity):** Determined by time horizon, wealth relative to liabilities, income stability, and liquidity needs. Longer horizons and greater surplus increase ability.
• **Willingness (psychological comfort):** Determined by behavioral assessment, past responses to losses, and stated preferences.
• **Conflict resolution rule:** When ability and willingness conflict, the lower of the two governs. A client with high ability but low willingness should be invested conservatively (with education to potentially raise willingness over time).

Constraints (LLTU+U)

Five categories of constraints must be addressed in every IPS:

• **Liquidity:** Anticipated cash needs, emergency reserves, near-term spending requirements
• **Legal/Regulatory:** ERISA rules, trust provisions, foundation payout requirements, prudent investor standards
• **Time horizon:** Single-stage or multi-stage; longer horizons generally permit more risk
• **Tax:** Taxable vs tax-deferred vs tax-exempt status; impact on asset allocation and rebalancing
• **Unique circumstances:** ESG/SRI restrictions, concentrated stock positions, employer stock, legacy holdings, personal preferences

Asset Allocation Policy

Strategic Asset Allocation (SAA) defines long-term target ranges:

• Example ranges: equity 50-70%, fixed income 20-40%, alternatives 0-15%
• Ranges permit tactical tilts within policy bounds
• Policy allocation is the primary driver of long-term returns (commonly cited as explaining ~90% of return variability across time)

Rebalancing Policy

Specifies when and how the portfolio is brought back to target weights:

• **Calendar-based:** Rebalance at fixed intervals (quarterly, semi-annually)
• **Threshold-based (percentage-of-portfolio):** Rebalance when any asset class drifts beyond a specified band (e.g., ±5% absolute)
• **Combined:** Check at calendar intervals, rebalance only if thresholds are breached
• Wider bands reduce transaction costs but allow more drift; narrower bands maintain discipline but increase costs

Benchmark Selection

An appropriate benchmark must be:

• **Investable:** Represents a viable passive alternative
• **Measurable:** Returns can be calculated on a timely basis
• **Specified in advance:** Chosen before the evaluation period, not after
• **Appropriate:** Matches the portfolio's asset classes, style, and risk profile
• **Owned by the manager:** The manager should agree the benchmark is fair

Manager Selection Criteria (The Five Ps)

• **Philosophy:** Clear, coherent investment belief system
• **Process:** Systematic, repeatable approach consistent with philosophy
• **People:** Experienced, stable team with aligned incentives
• **Performance:** Track record evaluated against appropriate benchmark over full market cycles
• **Price:** Fees competitive relative to peers and value added

Review Schedule

• **Annual IPS review:** Reassess objectives, constraints, and circumstances
• **Quarterly performance review:** Evaluate returns, attribution, and benchmark comparison
• **Trigger-based review:** Major life events, market dislocations, or material changes in circumstances

Key Formulas

| Formula | Expression | Use Case | |---------|-----------|----------| | Required nominal return | R_nom = spending_rate + inflation + fees | Endowment/foundation return target | | Required return (goal-based) | Solve: PV(assets) = Σ [CF_t / (1+R)^t] | Individual required return | | Real return from nominal | R_real ≈ R_nom - inflation | Converting between real and nominal | | Spending amount (rolling avg) | Spend = rate × (1/3)(AUM_t + AUM_{t-1} + AUM_{t-2}) | Endowment annual distribution | | Rebalancing trigger | |w_actual - w_target| > threshold | Threshold-based rebalancing |

Worked Examples

Example 1: IPS for a 45-year-old pre-retiree

**Given:** Age 45, current portfolio $2M, needs $100K/year (today's dollars) starting at age 65, life expectancy 90, inflation 2.5%, portfolio fees 0.5%. **Calculate:** Required nominal return and the resulting allocation guidance. **Solution:** 1. Time horizon: 20 years to retirement + 25 years in retirement = two-stage horizon. 2. At retirement, need $100K × (1.025)^20 = $163,862/year in nominal terms. 3. Required nest egg at 65 (25-year payout, assuming the retirement portfolio earns ~5% real, roughly 7.5% nominal at 2.5% infl