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Investment Policy Statement

Now that we have discussed some characteristics of individual investors, we will try to construct an Investment Policy Statement (IPS) for an individual. Recall that the basic IPS outline consists of return and risk objectives and constraints. We will examine a hypothetical investor and try to construct an IPS for this individual. The IPS is a valuable process for both the client and portfolio manager. The IPS must be consistent with the individual’s objectives and constraints. Therefore, it is an important communication tool that helps ensure the client and manager are aware of the specific needs and constraints of the client.

The following example for Sue and George Smith will give you an idea of how an IPS is outlined for a specific individual. You should try to outline an IPS and asset allocation strategy for them prior to looking at the suggested answer. This part of the assignment will not be graded and solutions are provided, but be sure to attempt to create your own before looking at the solution.

Next the graded part of the assignment will be to create an IPS for your hypothetical investor in the investment challenge. This assignment is outlined in bold at the bottom of this page. When creating the asset allocation strategy you should use more current market expectations (or base them off of more recent historical averages).

Sue and George Smith Practice Example

Sue Smith is 65 years old and is mentally well, but physically suffering from a degenerative disease. Unfortunately, she is expects to live for only a few more years. Sue’s major expenses are related to medical expenses. She no longer goes out and therefore her other expenses are small and predictable. She also likes to contribute to charities and provide gifts to her son, George, and his family with any excess income. George Smith is 45 years old and married. Sue Smith describes George as somewhat irresponsible but a good father, husband, and son. Sue grew up with stories of the Depression from her parents and therefore has a very conservative investment perspective.

George Smith is currently unemployed and helps out around the house looking after three children. Two of his children are in high school preparing for college and his oldest son is in college. His wife is also unemployed and is a homemaker. George is an aggressive investor and believes investors can double their money every five to six years. In addition to helping his children finance college, he hopes to give them money to start up their own businesses after college. George Smith and his family currently live on $100,000 of income after taxes. This income is primarily from investment income from wealth inherited when George’s father passed away and gifts from his mother Sue. George is seeking investment advice to increase his portfolio wealth so that he is less dependent on his mother. The following two exhibits summarize the current financial positions of Sue Smith and George Smith. In addition to the information in Table 2.2, George Smith has an additional $250,000 that is not listed under cash, that he wants to invest as well. This brings his total investable assets to $1,800,000.

Table 2.1 Investment Portfolio of Sue Smith

Market Value

After-Tax Yield

Cash Equivalents

$ 1,000,000

1.0%

Growth Stocks

1,500,000

1.5%

Cyclical Stocks

2,000,000

3.0%

Defensive Stocks

3,000,000

2.5%

Tax-exempt Bonds

5,000,000

5.0%

Real Estate*

2,000,000

6.0%

$ 14,500,000

Table 2.2 Investment Portfolio of George Smith

Market Value

After-Tax Yield

Cash Equivalents

$ 50,000

1.0%

Growth Stocks

250,000

1.5%

Cyclical Stocks

350,000

3.0%

Defensive Stocks

250,000

2.5%

Venture Capital Fund

150,000

0.0%

Tax-exempt Bonds

200,000

5.0%

Real Estate*

300,000

6.0%

$ 1,550,000

* Real Estate total does not include personal residence.

Table 2.3 Economic Market Outlook

Above Average Economy (60% Probability of occurance)

Asset

Expected Return

Expected Annual Yield

Cash Equivalents

1%

1%

Domestic Stocks

15%

4%

Domestic Bonds

7%

7%

International Stocks

19%

3%

Tax-Exempt Bonds

5%

5%

Real Estate

12%

10%

Average Economy (35% Probability of occurance)

Asset

Expected Return

Expected Annual Yield

Cash Equivalents

1%

1%

Domestic Stocks

9%

4%

Domestic Bonds

7%

7%

International Stocks

12%

3%

Tax-Exempt Bonds

5%

5%

Real Estate

10%

10%

Below Average Economy (5% Probability of occurance)

Asset

Expected Return

Expected Annual Yield

Cash Equivalents

1%

1%

Domestic Stocks

-5%

2%

Domestic Bonds

8%

8%

International Stocks

-9%

1%

Tax-Exempt Bonds

6%

6%

Real Estate

0%

5%

IPS and Asset Allocation Solution for George Smith

Try to recommend a solution for George Smith based on the needs expressed above. After you have outlined an IPS for George Smith use the information in the above tables to recommend an Asset Allocation for him. While there may be multiple recommendations that meet his needs keep in mind that most financial advisors try to meet the return needs of the individual with the least amount of risk as possible. After you have found a recommendation check your recommendation against the one provided under the Files link as described below. This example should provide you with additional insights to prepare the IPS and Strategic Asset Allocation in the Investment Challenge Step Three Assignment.

Investment Challenge Step Three Assignment

Graded Individual Assignment

Create an Investment Policy Statement & Strategic Asset Allocation for a hypothetical investor. You must turn in one IPS as a document and one Strategic Asset Allocation as an Excel file. You do not need to turn in an IPS for George. The suggested solution for this above example is provided on Canvas under Files then Course Resources then Module 2.

Below is the grading rubric for this assignment, along with data you can use for expected returns for your strategic asset allocation portion.

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