The intelligent and prudent management of investment decisions requires that you maintain a rational, consistent investment process. You can accomplish the lion share of your client’s investment goals and objectives by implementing a simple decision-making process.

You demonstrate prudence by the process through which a client’s investment decisions are managed. No strategy or investments are imprudent on their face. It is the way in which they are used, and how decisions as to their use are made, that will be examined to determine whether the prudence test has been met. Even the most aggressive and unconventional investment can meet the standard if arrived at through a sound process; while the most conservative and traditional one may not measure up if a sound process is lacking.

Successful investment professionals have many different approaches, but virtually all develop clear, unambiguous investment strategies and apply them consistently. This discipline is the key defining characteristic of all great investment professionals.
When you provide clients comprehensive and continuous investment advice, you need to demonstrate that you are following a prudent investment process that is based on:

  • Industry best practices;
  • The best interests of the client; and
  • Generally accepted investment theory.

The investment strategy should:

  • Represent the greatest probability of achieving the client’s long-term goals and objectives (Dimension 1.2);
  • Be consistent with the client’s unique risk/return profile (Dimensions 2.1 and 2.2); and
  • Be consistent with your own implementation and monitoring constraints (Dimensions 4.1 and 5.1).

Considerable research and experience has shown that the choice of assets (staff and money managers) and asset classes, and subsequent allocation of each, will have more impact on the long-term performance of an investment strategy than any other factor.

At this point, it may be worthwhile to comment on the use of optimization software. Yes, you need to have good asset allocation tools—particularly in determining the allocation between equities, fixed income, and cash.

Over the years, we have seen advisors make some of the following mistakes when developing an asset allocation strategy:

  • Believing that asset allocation is a science, and implying a level of precision/confidence that simply is unwarranted. There is still an element of art and uncertainty involved in the development of an appropriate asset strategy. Once the critical allocations have been made between equity, fixed income, and cash; the allocation to additional asset classes can be determined with common sense through an intuitive process. Despite advances in portfolio modeling, not all asset allocation decisions have been reduced to a computerized solution.
  • Not involving the client in the asset allocation discussion: If the client is not fully engaged in the process—not understanding the rationale for the asset strategy you are suggesting—it’s likely that the client will bolt at the first sign of market volatility.
  • Over-allocating—too many asset classes included in the strategy. Making an allocation of less than 5% rarely makes good sense: (a) it probably will not materially change the risk/return profile of the overall portfolio; and (b) it will be costly, both in terms of implementation and monitoring.
  • Making an allocation to an asset that cannot be properly implemented or monitored. A good rule of thumb to follow: If you lack the time, inclination, or knowledge to conduct appropriate due diligence—be it of an asset class or an investment manager—stay clear of the strategy or the manager.
Number of Asset Classes in Strategy Asset Classes Added Asset Classes
3 Domestic Equity, Fixed Income, Cash
4 Domestic Equity, Fixed Income, Cash International Equity
5 Domestic Equity, International Equity, Fixed Income, Cash Small Cap (Split Domestic Equity into Large Cap and Small Cap)
6 Large Cap Equity, Small Cap Equity, International Equity, Fixed Income, Cash Broad Fixed Income and Intermediate Fixed Income (Split Fixed Income to Broad Fixed Income and Intermediate Fixed Income)
7 Large Cap Equity, Small Cap Equity, International Equity, Broad Fixed Income, Intermediate Fixed Income, Cash Large Cap Value and Large Cap Growth (Split Large Cap Equity into Large Cap Value and Large Cap Growth)
8 Large Cap Value, Large Cap Growth, Small Cap Equity, International Equity, Broad Fixed Income, Cash Emerging Markets
9 Large Cap Value, Large Cap Growth, Small Cap Equity, International Equity, Emerging Markets, Broad Fixed Income, Intermediate Fixed Income, Cash Real Estate and/or Commodities

Your role as the financial adviser is to maximize the benefit to be gained from the Behavioral Governance framework—that is, to maximize the likelihood of your clients achieving their long-term goals and objectives (Dimension 1.2). It will be your actions as the steward of the planning process that will have the greatest impact on your clients’ success.

In our opinion, the development and ongoing maintenance of the client’s investment strategy is the most important function you perform as an investment advisor.

Complaints and/or lawsuits alleging misconduct are likely to increase as investment strategies become more complex and our capital markets become more volatile. However, contrary to popular opinion, liability generally is not determined by investment performance, but by whether a prudent process was followed.

As a best practice, the client’s investment strategy should be communicated in writing:

  • In the case of clients serving in a fiduciary capacity (trustee or investment committee member of a retirement plan, foundation, endowment, or personal trustee), the written strategy is the essential document that auditors, regulators, and the courts will review to help determine whether investments are being prudently managed.
  • For the individual investor, the strategy provides logical guidance during periods of market volatility and uncertainty.
  • For the investment committee, particularly one with a high turnover of members, the strategy keeps future members from second-guessing the actions of the original members.
  • The written strategy provides a paper trail of polices, practices, and procedures for investment decisions. The document can serve as critical evidence used in the defenses against litigation or accusations of imprudence.
  • The strategy provides a baseline from which to monitor investment performance of the overall portfolio.
  • For estate planning purposes, the strategy should be included and coordinated with other estate planning documents; providing less sophisticated heirs and executors appropriate guidance for continuing the prudent management of the client’s investment program.

You need to develop the investment strategy with the understanding that it will be implemented in a complex and dynamic financial environment. The investment strategy will produce the greatest benefits during periods of adverse market performance—the strategy acting as a stabilizer for clients who otherwise would be tempted to alter their sound investment strategy because of irrational fears. Its mere existence will cause clients to pause and consider the external and internal circumstances that prompted the development of the strategy in the first place.

This is what the substance of good policy development is all about: the framework and process that will allow cooler heads and a longer-term outlook to prevail. In periods of financial market prosperity, almost any investment program, no matter how ad hoc, will likely generate impressive results. In those circumstances, the advantages of a comprehensive the written investment strategy and the time devoted to its development may appear to be marginal. However, even under favorable market conditions, the stated strategy may reduce the temptation to increase the aggressiveness of an investment program as clients attempt to extrapolate positive current market trends into the future.