What is the portfolio management process and how do you write an Investment Policy Statement?

Question

AcadiFi · Accepted Answer

The portfolio management process is a structured approach that CFA Level I introduces and Level III tests extensively. It has three phases:

**Phase 1: Planning**
- Understand the client's needs, goals, and constraints
- Create the Investment Policy Statement (IPS)

**Phase 2: Execution**
- Develop capital market expectations
- Construct the portfolio (asset allocation + security selection)

**Phase 3: Feedback**
- Monitor and rebalance
- Evaluate performance against benchmarks

**The Investment Policy Statement (IPS):**

The IPS is the governing document that guides all investment decisions. It has two major sections:

**A. Objectives (the "what")**

1. **Return Objective:** What rate of return does the client need?
   - Example: Miranda Chen, age 42, has a $1.2 million portfolio and needs $65,000/year in retirement income starting at age 62. Her required real return is approximately 4.8% after inflation.

2. **Risk Objective:** How much volatility can the client tolerate?
   - **Risk tolerance** (willingness): The client's psychological comfort with losses. Miranda says she "can't sleep at night" if her portfolio drops 15% — her willingness is below average.
   - **Risk capacity** (ability): The client's financial ability to absorb losses. Miranda has a stable $185,000 salary, no debt, and 20 years until retirement — her ability is above average.
   - **Key rule:** When willingness and ability conflict, the *more conservative* one governs. Miranda's overall risk tolerance = below average.

**B. Constraints (the "how")**

1. **Time Horizon:** Miranda has a 20-year accumulation phase, then a 25+ year distribution phase. Longer horizons generally allow more equity exposure.

2. **Liquidity Needs:** Does the client need cash soon? If Miranda is buying a $380,000 vacation home in 2 years, that amount must be in liquid, low-risk assets.

3. **Tax Considerations:** Is the account taxable or tax-deferred? Tax-deferred accounts (401k, IRA) favor bonds (since interest is taxed at ordinary rates). Taxable accounts favor equities (lower capital gains rates).

4. **Legal and Regulatory:** Fiduciary standards, ERISA rules for pension funds, trust restrictions.

5. **Unique Circumstances:** Ethical exclusions (no tobacco stocks), concentrated stock positions, expected inheritance, etc.

**Putting It Together for Miranda:**

| IPS Component | Miranda's Situation |
|---|---|
| Return objective | 4.8% real |
| Risk tolerance | Below average (willingness governs) |
| Time horizon | 20 years accumulation + 25 years distribution |
| Liquidity | $380,000 needed in 2 years |
| Taxes | Mix of 401k and taxable brokerage |
| Unique | No fossil fuel investments (ESG preference) |

**Exam Tip:** The most commonly tested concept is the conflict between risk willingness and risk ability. Always go with the more conservative of the two. Also remember that the IPS should be reviewed and updated whenever there's a major life event (marriage, job change, inheritance).

For structured IPS practice problems, check out our CFA Level I question bank.

What is the portfolio management process and how do you write an Investment Policy Statement?

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