Chapter 6

Investment Strategy

The plan

‘If you don’t know where you are going, you’ll end up somewhere else’

Yogi Berra

Once you have formulated your investment objectives and constraints the next step in the investment management process is setting an investment strategy that has the highest likelihood of meeting your objectives whilst complying with the constraints.

Investment strategy (investment policy) is the plan of how you will position and manage your portfolio, aiming to achieve your desired outcomes given your risk tolerance. It is made up of a top-down asset allocation, deciding how much to invest in each asset class, and a bottom-up investment selection, deciding which investments to use under each asset class.

The future is unknown. But even if it is different from what you thought it would be, you must plan for it.

Investment strategy depends on two sets of factors. The first set is your particular internal objectives and constraints. It defines what you want to achieve. The second set is external factors of economic conditions. It determines whether and how you can achieve your objectives, depending on what financial markets are delivering.

For example, your goal is 8% annual average return over the next 10 years. Achieving this could have been possible during the 1980s and 1990s when both equities and bonds performed strongly. But it would have been unlikely to achieve during the 2000s when equity markets suffered two material bear markets in 2000 and 2008, taking off again only after 2011.

Planning appropriately is not always enough; you need financial markets to be supportive. There is a big element of luck in investing – it is better being lucky than smart. Adapt your plans and expectations based on market conditions.

Each combination of desired outcomes, risk tolerance and constraints necessitates a different plan. For example, long-term aggressive growth calls for an investment strategy focused mainly on risky assets, like equities. For income generation, a conservative strategy, focused on high-yielding investments, like bonds, may fit. When time horizon is short, the strategy should focus on preserving capital through low-risk investments.

As investment objectives and constraints change over time, so does the strategy – it is dynamic. Each phase of your overall time horizon may require a different strategy to address your needs and risks at the particular phase.

Formulating an investment strategy should begin at understanding the typical return and risk objectives during different phases of a typical saver’s life. It demonstrates how to plan a strategy for each phase. Subsequent chapters will cover these strategies and characteristics of different investments.

Investment Policy Statement

An Investment Policy Statement (IPS) is a document listing your objectives, constraints, investment strategy and rules for managing the portfolio.

This document can aid in following a disciplined process. Sometimes, when markets crash, all you see is gloom and doom. Feeling punished, you want nothing more than getting out of the market. An IPS can remind you what the long-term plan is, helping you avoid acting recklessly and emotionally. Clear investment strategy and IPS can help make rational investment decisions.

Drafting an IPS is not mandatory. It guides some people, whilst others view it as an unnecessary burden. It is a common practice when institutional investors hire portfolio managers to outline in writing the portfolio management’s rules.

You are an individual investor. You are managing your private portfolio. You may hire fund managers to manage portions of it, such as equities, bonds and cash. But you hire them through buying shares in publicly available funds they manage. You do not need to draft any documents or investment management agreements (IMAs).

It is entirely up to you. Draft an IPS only if you think it can assist. Use it to summarise all the information on your savings and investments. But do not do it if it is a nuisance.

For example, you should keep track of how much your employer and you contribute every year to your pension, where you are relative to your annual and lifetime allowances, and how much you have saved in ISAs. An IPS can help keep track of your actions and to-do-list.

Account aggregation views your entire assets. IPS can form one consolidated, holistic view of your wealth across different accounts.

For instance, if you own a house, you have large exposure to the property market. It may make no sense to invest in commercial property in your pension, doubling up your exposure. If you hold cash in your current and savings bank accounts, you should probably avoid it in your pension and ISAs. If you hold stocks in your ISA, consider holding fewer in your pension. And so on.

Summarising everything in an IPS can support considering the big picture, whilst not forgetting the small details.

Table 6.1 shows a basic IPS for illustration.

Table 6.1 Illustrative IPS

Summary

• Investment strategy is the plan of what you will do to increase the likelihood of achieving your target investment outcomes, in line with your risk tolerance whilst complying with your investment constraints.
• To formulate a strategy, understand the general financial goals for each phase of your life cycle, the characteristics of different investments and how to blend them into an asset allocation to match the return and risk objectives of each phase of your life cycle.
• Investment Policy Statement (IPS) outlines the investment objectives, constraints, strategy and rules for managing your portfolio.
• IPS can help with aggregating all your assets to form a holistic view of your wealth whilst keeping track of all your actions.
• Keep your plan flexible. While planning and following a plan are essential, reality is likely to make you change your plan.