Before committing yourself as an investor to any investment, it is imperative that one should have clear and identifiable Objective and Constraints (Investor self profiling). Doing so ensures that the investor commits his/her funds in the most rational manner. Actually most of us haven’t actually started framing an IPS (Investment Portfolio Statement) for our self at all. We are driven by thoughts like:
- Do we need to do this?
- Can’t we directly jump into trading without all this?
- This only works for sophisticated investors and not for us
We all should devote some of our investing time in framing the individual IPS (or get someone do it for us). We are here to give an over view only to the different ingredients of what goes into making a good IPS and how is it useful to all of us.
To state it in one line, IPS is a document which identifies one’s Investment Objectives and Constraints. Why are you investing? What are your goals? How much risk can you bear?
Once you understand the purpose, IPS will sound more Relevant and Interesting to you. It’s more Process Oriented, Less Mathematical and No Formula or Technicalities. Basically it summarizes the relevant fact and concludes the Investment strategy of one self.
MAIN INGREDIENTS OF IPS:
- IPS Objectives (Risk and Return)
As a Return Objective you should list down your required (more priority goals) and desired objectives. Goals like having a retirement, child’s education; child’s marriage etc. has to be noted down. Also, the Risk Tolerance has to be noted down, Risk in terms of both Ability and Willingness.To understand risk you have to do “situational profiling” of yourself and it’s done by understanding your biases, preferences and perceptions.
- Active Wealth creator has higher willingness towards risk
- If perceived self wealth is more, one will take more risk
- Stage of Life also matters
Risk and return goes hand in hand. If you can’t take more risk, you can’t get more returns. This does not mean you have to take lot of risk. The only point is your Return objective has to match your willingness and ability to take risk.
Objectives should also be consistent with Capital Market expectation (Economic forecast and its effects on different sectors/industries of the economy) and one’s constraints.
- IPS Constraints (Time, Liquidity, Tax, Legal and Unique)You should list down different constraints under which the investments have to be made, as they are more likely to limit your risk taking abilities and in turn hamper the return objectives. Different individuals face different types of Constraints and they have been grouped into different categories like, Time constraint, Liquidity constraint, Tax constraint, legal constraint and unique constraints.
- Time Constraint (How much is timeframe of the investment): This is critical because if we have a longer time frame, we do not have to worry about the short term market fluctuations and can concentrate on more long term investments. The age of the individual is one of the factors which determine his/her time constraint.
- Liquidity Constraint: It determines how much dependent; the individual is on the Investment. Does he/she have sufficient emergency reserve or other sources of income to meet the ongoing and or sudden fund requirements?
- Tax, Legal and Unique Constraints: Similarly Client should be aware of the before and after tax returns from the investment, the Legal constraint under which he/she can make investment and any specific Unique Constraint he/she may be subject to.
It’s better to approach IPS in a reverse order, meaning first analyze your constraints, then the risk tolerance and then the return objective. Because Constraint affects your risk tolerance and which affects the Return objective.