Investment Policies, the second step!


Once I’m ready with my investment objective I have to settle down all the ideas into something more concrete. In other words, I have to constitute my investment policies, the rules of the game. The investment policies will govern my decision making process. Just to recall, the investment policies are important because they help me:


To keep track of the degree of accomplishment of my investment goal. If I want to know how are my investments going I can evaluate them and say something tangible like: “I am X% better than my objective”, “my returns are $X lower than what I expected” … a lot better than a “I hope I’m doing well”.


To keep track of the risks. In my investment policies I have to establish a quantitative method to measure risks to keep a permanent track of them. It’s not the same to have an expected return of 5% with a 50% chance of losing all than an expected return of 5% with a probability of losing all of just 0.05%.


To establish my investment strategy. It is important to establish the rules that would dictate where am I going to invest, for how long should I invest, how am I going to invest, etc.


This rules are made for my benefit; if I can’t adhere to them I should not be investing. The rules are going to help me with the interaction among my expectations of the market, my investment objectives and the restrictions.


The minimum elements my investment policies should have are:


  1. Broad investment objective. Why do I want to invest? How much risk am I willing to take and how much risk I can actually take?
  2. The objectives of my investment policy. How are the policies going to help me to achieve my goals?
  3. Concrete investment objectives. What return do I need to achieve? How am I going to measure the return? For how long should I need to invest in order to achieve my goal?
  4. Risk limits and an assessment of risks. To what risk factors am I exposed? How am I going to measure the risk? What risk limits am I going to establish?
  5. A procedure to follow up the investment strategy. How am I going to measure my strategy versus another strategy? What is my benchmark?
  6. Investment strategy. In what assets I want and can invest? In what quantity? How am I going to decide when to buy and sell? What is my investment process?
  7. A procedure to evaluate my investment objectives. My objective is still the same? My risk aversion has changed? Did my universe of assets change? The benchmark does reflect my objectives? Can I improve the investment policies?


Let’s see an example. I like the REITs thing going on and I want to live from their dividends. The core of the investment policies will be the following:


  1. Broad investment objective. Invest enough during the following 5 years, without sacrificing my current expenses, so that I can live from the cash flows of the REITs starting 6 years from now.
  2. The objectives of my investment policy. The investment policies will have clear calculation methods of returns and risks. It will have my investment strategy and a process to evaluate that strategy. Finally, a clear process to sell and buy assets.
  3. Concrete investment objectives. 1) Invest $12,500 each month for the next 60 months, 2) invest in a portfolio with a target return of 10.22% annually, 3) reach an amount of $973,000 at the end of the 60th month, 4) invest that amount in REITs and achieve a cash flow of $5,274 each month.
  4. Risk limits and an assessment of risks. 1) the portfolio shall not have a daily VaR (historic) at 95% bigger than $9,700, 2) the ratio of annual return/ annual volatility shall not be more than 0.75. 3) the allocation in a single asset shall not exceed 40% of the total value of the portfolio, 4) monthly contributions shall not compromise my normal expenditures.
  5. A procedure to follow up the investment strategy. The benchmark is the Mexican IRT. Next Chapter >>
  6. Investment strategy. Next Chapter >>
  7. A procedure to evaluate my investment objectives. 1) Monthly calculation of the returns (daily, monthly and yearly returns), 2) monthly calculation of the benchmark (daily, monthly and yearly returns), 3) evaluation of the over-under performance of the last month, 4) if I’m under performing, evaluate the investment strategy, 5) monthly calculation of risk measures (daily, monthly and yearly observations), 6) search for any deviation from the target risk limits and re-balance the portfolio if those deviations exist.


It is important to remember that this is the base of our investment policies. The main objective is to create a more detailed document. The next step is to define the investment strategy. Next chapter >>


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