Investment Policy Statement, III - The Deeper Questions

Investment Policy Statement, III – The Deeper Questions

Boy! Was I naive!

Kind of like my thinking with respect to estate planning ten years ago, I thought writing an Investment Policy Statement should be pretty straightforward. All I needed, I thought, was some professional help to give me the right words.

But I’ve discovered that is not the case at all–a discovery that is both frustrating (because it means I have a lot more work to do!) and happy at the same time (because I made the discovery; I haven’t made any more foolish or irrevocable mistakes in this area . . . yet).

Way beyond getting the “right words” on paper, Sarita and I need to answer some very fundamental questions–questions far deeper than the average investment advisor is likely to ask or help us answer.

I think I would like to begin my discussion about these questions with a reference to my most recent conversation, this morning, with our legacy planners.

If you read my last post in this series, you would know I had focused, primarily, on two aspects of the sample Investment Policy Statement the legacy planners sent our current investment advisor.

On the need for separate and distinct policy statements for each of the entities we oversee. (As I expressed it in the letter I sent seeking help from our current investment advisor: “I sense each [account] needs to have distinct time horizons, asset allocation guidelines, risk tolerance statements, and so forth.”)

And–of much greater concern, because it seemed so intractable:

On how to phrase an “Asset Allocation” policy with which I could be comfortable.

After more than a week of banging my head against these problems (but primarily the issue of asset allocation–especially in the midst of a dynamic business cycle), when I mentioned these concerns to our legacy planners, they said, “Don’t worry about asset allocation. That will come later. That’s a functional ortactical question. At this time, we want to work at the more theoretical or strategic level. The question we need you to answer has to do with What are you trying to achieve? What do you want to achieve?”

Oh! –That rocked me back a bit!

I confessed to them: “I have been thinking a bit–way back in the most remote recesses of my mind–that I don’t even know why we want or need all this money. At the same time, I don’t want to squander it. And I don’t want to give so much away that I put the ‘golden goose’ that produces it at risk. . . . But, really, it gets me thinking again (as I was a year ago): ‘Why not just get rid of it. Give it away. Why invest all this time and energy in multiplying financial resources? . . .” –It’s the question our current legacy planners asked us last May when they first interacted with us: Would we consider not just charity (short-term gifting) but stewardship (long-term, fiduciary management of an asset to maximize profitability for good purposes)?

When they explained the difference back then, we agreed we wanted to go the stewardship route. Will we stick with it? (I expect so, but it’s a hard row to hoe!)

Anyway. So. Yes. What do we want to achieve? –A fundamental question. A question deeper than the specific contours of our risk tolerance, our time horizon, and so forth. Indeed, the correct answers to these latter questions grow out of our honest and thoughtful answers to the question of goals.

It was as I thought about these things that I realized, in this area, too–just as in legacy or estate planning as a whole–advisors will readily permit you to dig a hole for yourself by having you answer a few basic questions and then assuming they know the answers to all the questions that are likely to impinge on your financial decision-making process.

Except they don’t. Because they can’t. Because they don’t know your fundamental goals. Because, possibly, you haven’t defined those goals clearly, even, for yourself.

And y’know something? Just as most estate planning professionals seem poorly equipped to help you sort out your estate planning goals, so, too, your investment advisors are likely poorly equipped to help you sort out your investment goals.

For example, two standard questions most investment advisors will ask include: “What’s your time horizon for these investments? (When will you need this money?)” And, “What’s your risk tolerance?”

And then they offer a series of standard answers from which to choose

With respect to time horizon:

1 to 3 years
3 to 5 years
5 to 7 years
7 to 10 years
More than 10 years
Other time period. (Please describe: __________.)

And with respect to risk tolerance:

I cannot accept any loss of principal.
Conservative: I am more concerned with preserving the value of my account than maximizing capital growth, and can tolerate declines in value through a market cycle.
Moderate: I am comfortable with fluctuations in my portfolio, and the possibility of larger declines in value, in order to seek to grow my portfolio over time.
Aggressive: I am comfortable taking on high levels of risk, and the possibility of large fluctuations and substantial declines in the value of my portfolio, in pursuit of higher levels of appreciation in my portfolio over time.

All of these answers were fine as far as they went. But the more I got into this issue of policy statements, the more I realized these questions and proposed answers failed to dig deep enough. I felt as if they backed me into corners where I didn’t want to be. For example:

I’m not sure when we will need money. . . . In general, I’m thinking of most of the funds we save as being “For ‘a rainy day.’” “For ‘our retirement’ (which, I hope, won’t come for 20 years or more).” Etc.

But when will “a rainy day” come? And how bad will the “storm” be? . . . Or what if it’s not a storm at all, but an opportunity . . . a tremendous business opportunity . . . or a really juicy philanthropic proposal? . . . What if one of our kids or grandkids or someone else we know faces an unexpected crisis? . . .

In a sense: What is this money for?

Truth is, we haven’t really answered this question (or these questions). And, frankly, our investment advisors are ill-equipped to help us answer them. We come with money in hand and they ask us how we want to invest it: for what kind of time horizon and with what kind of volatility.

And so, if we tell them we’re looking at a greater than 10-year period, they’ll say, “Fine.” And leave it at that. . . . But, honestly, I don’t think we’re really comfortable with the 10-year time horizon because, I sense, inside, in our heart of hearts, we know it might be shorter than that. Or, at least, some of it might be.

Worse: We know–especially because of our experience in the last year or so–that if we say we have a 10-year time horizon, most investment advisors will take us at our word. And if we get hit halfway through that 10-year period (as we did this past year) with a 40% decline in the value of our portfolio . . . as far as they are concerned, “That’s tough. Those are the risks you have to take to maximize earnings over the long-term.”

But that’s not what we want!

(But what do we want?)

This morning, as our legacy planners and I talked, they pushed me to consider the following more strategic questions.

In essence, they said, “Don’t think of all your money together. And quit worrying about asset allocation. And don’t think about risk right now.” Instead:

What are the different structures–or entities–you own (or for which you have fiduciary responsibilities) for which you ought to have separate and distinct IPS’s?

Then,

Once you create a list of all the entities for which you need separate IPS’s: What kinds of financial goals do you have (or should you have) for each of these entities?

“Notice,” our legacy planners said, “most entities need to pursue more than one financial goal.” For example, Stephen J. Huxley and J. Brent Burns note that many of us need both income portfolios and growth portfolios–the one to fund current and short-term cash needs, and the other to guarantee long-term wealth preservation in the midst of inflation and confiscatory taxes.

Our legacy planners suggested we may need to divide our assets three ways–into “growth,” “preservation,” and “cash”– roughly equivalent to long-term, medium-term, and short-term/immediate.

So, this afternoon, I created a list of entities and attempted to think through which kinds of portfolios each one would require.

What does each of the following need in the way of “growth,” “preservation” and “cash” or “income”?

Our business.
Our company’s defined benefit plan (whose assets, many of them, are owned by our employees, but for which we are fiduciaries).
Our company’s and our family’s private foundations (for which we have fiduciary responsibilities).
Our family’s limited partnership (another entity in which Sarita and I own many of the assets, but over which we are fiduciaries for the limited partners–our children).
Our personal wealth portfolio (held in several forms [cash, securities, and real estate, for example] and also held in several different entities [an LLC; our corporate defined benefit plan; and more]). . . .

For each one,

How much cash do we believe we need to have on hand for the next year or two “no matter what”? How much are we likely to need for the next three to ten years or so? And for retirement (say in 20 years)?
Is it possible that–and if so, how does–each one of these entities interact with the others? (Might one or more help to meet the potential needs of another?)

I haven’t yet answered these latter questions. I have only made the list of entities and suggested which ones need, within them, the separate “Growth,” “Preservation” and “Cash” policies as well.

And that exercise alone–just defining, sorting and categorizing the entities–has given me great hope that we will be able to clarify our goals and establish reasonable policies.

Having gotten this far, however, I have noticed that we are going to have to answer some additional questions before we set up our investment policy statements. Among them:

What kinds of returns do we think our investment methodologies will produce? (If you figure you’re going to need x dollars per year and you figure a certain investment method will produce a 10% average return per year, then you should only require 10x dollars to produce your necessary cashflow. But if you figure your investment will only produce a 7% return, then you’ll need just over 14x dollars. . . . –So the quantity of funds you figure you’ll need depend very heavily on your assumptions–and your confidence in your assumptions–in this area.)

And so it is with the next question, as well:

What kind of inflation rates do we expect to see over the next ___ years? (Obviously, if we feel the need to prepare for 10% or 20% annual inflation vs. an historical average inflation over the last century of 3.5% . . . the alternate assumption is going to make a large difference in one’s plans!)

There are more questions, but all of them–the questions I’ve just asked, and the others not yet mentioned–need to wait for another day.

Share and Enjoy: