IPS: Investment Policy Statement - risk profiling, asset allocation and mapping model portfolios

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What is an IPS?

The Planipedia IPS page gives you a definition of Investment Policy Statement and explains best practices how to produce it. The guides below, however, address key points of an IPS you face when go through the process in the software PlanpPlus-Planit and in the course of client communication when introducing and implementing suggested changes in the client's portfolio.

How to create an IPS

Creating an IPS Investment Policy Statement for clients should be an elementary step in financial planning. Put it simple, there is no financial planning w/o providing the client with an IPS! In PlanPlus-Planit IPS means a highly comprehensive personal risk profiling, assessing the client’s risk tolerance and risk capacity, measuring the client’s assets, creating portfolios for various (life) goals, linking the assets to portfolios and life goals, and allocating assets accordingly. This is the base for any other planning activities like Retirement Planning or Estate Planning etc. Awareness of the current investment profile of a client and the real impacts of his actions on his portfolio and the related Life Goals are very basics in financial planning again. The following short guides discuss three vital points of the Investment Planning process:

1. Risk Profile and Model Portfolio mapping

2. Asset Classes and Model Portfolios

3. Asset Allocation

Risk Profile and Model Portfolio mapping

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Model Portfolios are recommended after measuring the client’s risk profile, which is the result of his risk tolerance and available funds and its portfolio characteristics. The mapping process uses three concrete factors: risk tolerance, portfolio duration and flexibility. The result is a recommended/suggested investment portfolio fitting to the personal risk and investment profile. You can see the how-to here.----

- Risk profiling: Art and science - A short primer on the history and practice of modern risk profiling by Finametrica is here.

- Fifteen common risk profiling mistakes (and how to avoid them) - Paul Resnik, co-founder of FinaMetrica reveals the most common risk profiling mistakes, and how can we avoid them in this article.

- ESMA publishes MiFID guidelines to enhance investor protection - The European Securities and Markets Authority provides the guidelines for consumer protection by MiFID (Markets in Financial Instruments Directive) here.

- Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection - A guidance consultation by the British Financial Services Authority can be found here.

- Five myths of risk tolerance and how to understand them better - A comprehensive article on the client's perceived and real risk tolerance habits is available here.

- 20 due diligence questions for the provider of your firm’s risk tolerance test, Another Paul Resnik feature is available on this link.

Asset Allocation and Model Portfolios

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Model Portfolios are pre-set mixes of asset classes. Each Model Portfolio composed of various amounts/proportions of Asset Classes, which represent investment categories or products relevant to or characteristic for the client’s country or region, this guide explains how. MPs are on the Efficient Frontier, so they represent the theoretically achievable best risk-return position of a portfolio.

Asset Allocation screen

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This screen shows the composition of the current and target (suggested, recommended) portfolios. It reflects how the portfolios should be rebalanced, i.e. the assets reallocated (sell/buy) so that we can achieve the recommended portfolio. This guide gives a more detailed description.

4. Further important notes on the Investment Policy Statement

Like all models, also the Investment Policy Statement has its limits. The forecasting power of an IPS is as good as the implicit or explicit assumptions (parameters) and variables (inputs) of the underlying model, and supposed the context and functions proposed by the model are exact and real. The Markowitz model and the (Post)Modern Portfolio Theory both make several assumptions. Their adequacy and thus modeling and predicting power, or to put it in plain English, their reliability is disputed (or therefore limited). You can find more on this in the Wikipedia page's middle paragraphs ("Critisism"). There are many discussions how to adress the (potential) shortfalls of financial (investment) models, terms like the "New Normal" or the "Black Swan" (N. Taleb) give recent warning of the modeling illusion. Modeling has inherent risks like explained here demonstrated on Markowitz and the Post/Modern Portfolio Theory. According to Merk Insights, a comprehensive portfolio (management) model has 3 characteristics or in other terms business requirements: 1) Model, 2) Multicurrency, and 3) Monetary.

Legal compliance: First and foremost, investment advice in the European Union is regulated by the MiFID guidelines, and its implementation by the European Securities and Market Authority's Guide. The process and content of the whole advice practice should adhere to these standards.

The APT or Arbitrage Pricing Theory can be considered as an alternative model.

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