Steps in the Investment Management Process at AFM
Making sound investment decisions is not an easy task. The following describes the process we advocate at Alpha Financial Management. We believe that following these steps will significantly increase the odds of building and structuring an investment portfolio that will withstand the test of time. We believe that superior investment returns are a result of developing a prudent process or strategy, and then sticking with it. Our process incorporates both modern investment portfolio theory and management techniques that have been followed for many years by experienced, successful investors.
Step 1 – Analyze the Current Situation
Investment decisions should never be made in isolation or in a vacuum. All factors that may have a bearing on the decisions should be identified, analyzed, and integrated into the process, including the determination of the portfolio’s objectives.
The portfolio’s investment objectives specify the results that the investor would equate with a successful investment program. These differ from the broad statements of purpose or aspirations constituting the portfolio’s mission in that the objectives must be a list of quantifiable investment results expected to be achieved over a specified time horizon. For example, a common objective for a retirement plan is to produce a total rate of return that exceeds the rate of inflation by a certain amount.
In addition to determining the portfolio’s missions and objectives, the investor should analyze information and details relating to:
- The length of time a particular investment strategy can be followed (time horizon) until there is a significant disbursement.
- The portfolio’s cash flow (contributions/withdrawals).
- Regulations, trust documents, or legal instruments that may constrain investments to remain within certain asset classes, mandate certain asset mixes, or establish specific security guidelines.
- The types of risk to which the portfolio is exposed and the types of risk the investor is willing to accept.
Step 2 – Design Optimal Portfolio
A portfolio’s asset mix or asset allocation refers to the percentages that are invested in various asset classes, such as domestic stocks, domestic bonds, cash, real estate, international stocks, international bonds, and so on.
The investor’s role is to choose the appropriate combination of assets that optimizes risk and return objectives. The chosen asset allocation will be that unique portfolio that maximizes the investor’s return subject to a particular level of risk tolerance.
Step 3 – Formalize Investment Policy Statement (IPS)
This is the most important step in the process and is also the most glaring omission that many investors make. The IPS provides logical guidance during implementation of an investment strategy. The IPS ensures continuity of the investment strategy.
An IPS must be simple, forthright, and understandable. It should detail the investment mix and management structure, provide a strategy for automatically rebalancing the assets, provide for clear and enforceable performance standards, and define the duties and responsibilities for all parties involved in the management of the portfolio’s assets.
The IPS should be viewed as a business plan and the essential management tool for directing and communicating the activities of the portfolio. First and foremost, its purpose is to explicitly state the investor’s realistic long-term investment goals.
Step 4 – Implementation
Once the IPS has been approved, searches are commenced to select appropriate managers, a custodian, and transaction brokers. This step allows the use of separate accounts, money managers, and mutual funds.
The investor’s primary function is to set policy, and the primary function of the money managers is to maximize returns within mandated investment parameters.
Step 5 – Monitoring and Supervision
Monitoring the resulting performance of selected money managers and/or mutual funds and evaluating the continuing viability of meeting the investor’s objectives constitute the
final step of the investment management process. An effective monitoring program should provide the investor with sufficient information to evaluate the program’s strengths and weaknesses, and to keep the program on track in achieving the portfolio’s objectives.
The truly effective investor realizes that a crucial element of the decision-making process is establishing appropriate performance measurement standards:
- To facilitate good investor-money manager communications and to confirm the mutually agreed-upon goals of the IPS.
- To show whether the assets are being managed as directed by that IPS with respect to the portfolio’s risk tolerance and expected return.
- To support the qualitative judgments about the continued confidence, or lack of it, in the money manager’s abilities.
- To support the periodic consideration of the continuing appropriateness of the IPS.
Summary
Regardless of portfolio size, the investor benefits from a clear understanding of the role one should play in the management of investment decisions. Only by following a structured process can one be certain that all critical components of an investment strategy are being properly implemented.
The role of the investor is to maximize the benefits to be gained from the process – that is, to maximize the likelihood of achieving one’s goals and investment objectives.
Review Procedures
A long-term investment strategy requires alteration only when the underlying factors of the investment objectives change.
Despite the infrequent need for policy modification, periodic reviews can serve a very productive purpose. At least monthly, investors should analyze their custodian’s appraisal report containing the current market value of holdings and the previous month’s transactions and expenses.
On a quarterly basis, one should compare the asset allocation of the portfolio and the performance of money managers to benchmarks established in the IPS. If the situation warrants, the portfolio should be rebalanced back to the strategic asset allocation of the IPS.
At least annually, there should be a formal review to determine whether investment objectives are being attained or have changed. One should be particularly sensitive of the need to determine whether the investment strategy still holds the highest probability of meeting short-term liquidity needs and long-term objectives.
|