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IPS - Investor preferences and restrictions

2021.9.24 Vítor Ribeiro, CFA

Investor preferences and restrictions are part of the process of constructing the Investment Policy Statement or IPS.

Investors must take into account the restrictions, preferences and constraints that affect the investment plan. Such restrictions may derive from legal or regulatory imperatives or individual policies and may even be linked to specific risks that are relevant to the investor.


Restrictions on the Investment Policy Statement or IPS

On the side of restrictions, the following stand out:

  • Liquidity: related to short and medium-term liquidity needs, such as an emergency fund or a specific short-term objective;
  • Performance evaluation periods: such as a quarterly report to monitor the evolution of the portfolio and the degree of achievement of objectives.
  • Investment time horizon: one or several periods can be defined, with time being one of the main attributes of an investment plan and one of the critical factors for the plan's success.
  • Tax considerations: tax policy can compromise the objective return. The fiscal situation of investors and the fiscal impact of each investment decision on the portfolio's evolution must be known.
  • Legal restrictions: regulation has been increasing. It is essential to frame the portfolio in the regulatory context and unequivocal compliance with the respective regulations. For example, on the question of the adequacy of financial instruments and assets to the investor's portfolio.
  • Unique circumstances related to the investor or the investment strategy such as restrictions on investment in certain assets, investment according to ESG factors, restrictions on exposure to different currencies, portfolio leverage, among others.


Preferences in the Investment Policy Statement or IPS

In the IPS set of preferences, we identify those related to asset allocation, return and risk measures, and the portfolio's rebalancing process against target allocations.

An asset allocation policy must designate target allocations for each asset class, with allowable ranges around those targets. For example, if the weight of European shares is 10% in the total portfolio, the possibility of the allocation going above or below this target, within a certain range, must also be defined. The IPS must establish all permitted asset classes in which the investor will invest. Within each asset class, certain subclasses or themes subordinate to the main class can be identified.

The performance evaluation, in terms of return and risk, must also be defined at this stage. The portfolio's expected return, weighted according to strategic target allocations and the risk and investment profile itself, can be constructed and compared to the portfolio's actual performance. Likewise, some intuitions about risk exposures can be developed from the assessment of deviations from target allocations and violations of acceptable ranges of deviation.

In relation to performance metrics, risk assessment measures (such as standard deviation or maximum loss) and return (return weighted by time or money invested) and risk-adjusted return measures should be specified.

Acceptable variations outside the boundaries of the various asset classes in the portfolio must be documented in the IPS. The rebalancing mechanism can be integrated with the risk management system and can be defined by calendar (for example, annually) or whenever there is a deviation above the control range of each asset class or whenever there is a reinforcement of the investment portfolio.

Therefore, on the financial advisor's side, there is no alternative: you must always follow the investor's preferences and restrictions.


Numbers and narrative

More than including numbers or complex strategic considerations, IPS should help us understand and accept the future, as Tim Harford (an economist and journalist at the Financial Times, with an opinion column called “the economist in disguise”) puts it in the book. “How to make the world add up”.

The numbers and narratives we create are often used to confuse and create illusions. IPS, with the inclusion of the investment philosophy aligned with investor preferences and constraints, allows us a certain positive skepticism, as identified by a perfect quote from the book: “Naive realism is a powerful illusion”.

We must use data, statistics, information to better understand the financial market and make better decisions. But we won't be able to control it. Every day we will have little surprises, volatility and sometimes we will even see a black swan, as described by Nassim Nicholas Taleb. Because one thing is certain, bad news comes suddenly, while good news comes slowly and takes shape.

Although TINA is currently in force (there is no alternative or there is no alternative), we must reject this idea. There is always an alternative. The world is not binary, nor is it an objective fate, with a yes or no answer to everything.

It is important to think critically and be creative within individual logic. Sleeping well at night is one of IPS' goals. IPS is neither perfect nor static, but it helps investors not to be swayed!


Vítor Ribeiro, CFA
Vítor Ribeiro, CFA

Vítor is a CFA® charterholder, entrepreneur, music lover and with a dream of building a true investment and financial planning ecosystem at the service of families and organizations.

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