## **Learning Outcomes**

This article explains how to formulate a complete individual Investment Policy Statement (IPS) and link it directly to a defensible strategic asset allocation for private clients in the CFA Level 3 exam. It clarifies how to translate client goals and circumstances into precise, return‑focused investment objectives, and how to distinguish required return from desired or aspirational goals. It details how to identify, classify, and prioritize all standard constraints—liquidity, time horizon, tax, legal and regulatory, and unique circumstances—and shows how each constraint should influence portfolio design. It analyzes the components of risk tolerance by contrasting willingness, ability, and capacity to take risk, and highlights how to resolve conflicts between them in exam-style vignette questions. It discusses how to express recommendations using clear, concise IPS language that exam graders expect, avoiding vague phrasing or unjustified assumptions. It also reviews common candidate errors, such as overlooking short‑term cash flow needs, mislabeling constraints, or recommending allocations inconsistent with the stated risk profile, helping you sharpen judgment and improve scoring on individual IPS and strategic asset allocation questions.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand the practical aspects of IPS formulation for individuals, with a focus on the following syllabus points:

- Translating personal and financial objectives into clear investment objectives
- Identifying and classifying client constraints (liquidity, time horizon, taxes, legal, and unique needs)
- Recommending an appropriate strategic asset allocation
- Evaluating client risk tolerance and capacity
- Structuring the IPS for clarity and use in portfolio management

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which constraints must always be considered in an individual IPS for strategic asset allocation?
2. A client nearing retirement wants to maintain lifestyle, fund a daughter's wedding in three years, and minimize taxes. Identify two primary and two secondary constraints.
3. Briefly explain “risk capacity” as used in client IPS formulation.
4. What aspects of client information are essential for determining the appropriate time horizon in an IPS?

## **Introduction**

Strategic asset allocation for private clients is anchored in a robust Investment Policy Statement (IPS), which reconciles the client’s goals, risk profile, and constraints with investment strategy. An effective IPS serves as both a planning and management tool, ensuring disciplined, long-term portfolio decisions. CFA Level 3 requires candidates to demonstrate the ability to formulate IPSs, integrate client information into clear investment policy, and design suitable strategic asset allocations.

> **Key Term: Investment Policy Statement (IPS)**
> A written document outlining a client’s investment objectives, risk tolerance, and constraints. It sets guidelines for portfolio decisions and ongoing management.

## THE INDIVIDUAL IPS: OBJECTIVES AND CONSTRAINTS

The IPS for a private client consists of clearly stated investment objectives and a full set of client constraints, which together drive the choice of strategic asset allocation.

### Investment Objectives

Objectives should be clear, measurable, and prioritized. Most private clients aim for:

- Capital preservation or growth
- Lifestyle funding
- Long-term wealth transfer (bequests or philanthropy)

When specifying objectives, avoid vague language like "growth." Instead, detail the required cash flows or growth rates and note any secondary goals.

> **Key Term: Strategic asset allocation**
> The long-term mix of assets designed to achieve the client's investment objectives, given risk tolerance and constraints.

### Risk Tolerance

Risk tolerance is a combination of willingness (subjective attitude to loss/volatility) and capacity (objective financial ability to bear risk). Always assess both, as discrepancies are common.

> **Key Term: Risk tolerance**
> The degree of risk a client is willing and able to accept to achieve investment goals.
>
> **Key Term: Risk capacity**
> The financial ability of a client to sustain potential losses without jeopardizing objectives.

Risk perception—the client’s view of what is "risky"—may differ from tolerance or capacity and should be explored through conversation and, where appropriate, questionnaires.

### Constraints

Every IPS should systematically address the following constraints:

1. **Liquidity:** Need for cash to fund lifestyle, major outlays, or emergencies
2. **Time Horizon:** Length of time before assets are needed, and for how long
3. **Tax Considerations:** Personal, jurisdictional, and investment-specific tax issues
4. **Legal and Regulatory:** Any restrictions, such as employment rules, trust provisions, or jurisdictional limits
5. **Unique Circumstances:** ESG preferences, bequests, concentrated positions, or specific prohibitions

> **Key Term: Constraint**
> Any factor that limits, restricts, or conditions the portfolio strategy (e.g., liquidity, taxes, time horizon, legal, or unique requirements).

## INTEGRATING OBJECTIVES AND CONSTRAINTS INTO STRATEGIC ASSET ALLOCATION

Once objectives and constraints are clearly defined, the strategic asset allocation is constructed to maximize the likelihood of meeting goals within these boundaries.

### Typical Process

1. Summarize all cash flow requirements, major purchases, and milestones to determine the required rate of return and time horizon.
2. Assess the client's ability and willingness to accept portfolio volatility and losses.
3. Identify and classify all constraints clearly and succinctly.
4. Translate all of the above into asset class weights designed to deliver the required risk/return profile.

### **Worked Example 1.1**

**Scenario:**  
A client, age 55, plans to retire at 65, wants to fund a child’s graduate education in 5 years (\$100,000 outflow), and values capital preservation. She prefers not to invest in tobacco or gambling firms. The client’s portfolio is \$3 million, most of which is in a taxable account.

**Question:**  
Draft a simplified set of IPS objectives and constraints based on this scenario.

> **Answer:**  
> Objectives:

- Primary: Fund retirement income starting at age 65, supporting lifestyle for an expected 25-year retirement.
- Secondary: Fund child’s graduate education (\$100,000 in 5 years).
- Risk Tolerance: Moderate; values capital preservation.  
  Constraints:
- Liquidity: \$100,000 required in 5 years; ongoing annual withdrawals post-retirement.
- Time Horizon: 10 years to retirement; 25 years in retirement.
- Taxes: Taxable account—need to consider after-tax returns.
- Legal/Regulatory: None specified.
- Unique: Exclude investments in tobacco and gambling firms.

### **Revision Tip**

_Always list liquidity and time horizon constraints separately, and be alert for near-term outflows (e.g., education, major purchases) that may influence allocation and risk budget._

## STRATEGIC ASSET ALLOCATION CONSIDERATIONS

Strategic asset allocation is directly driven by the IPS. The process is iterative:

- Match expected returns (after-tax, if relevant) to the required return
- Respect risk tolerance signals—do not exceed risk capacity
- Adjust for all constraints (especially liquidity, tax, legal, unique)
- Test the allocation's robustness through scenario analysis (e.g., longevity, market downturns)
- Document the process and rationale in the IPS

### **Worked Example 1.2**

**Scenario:**  
A 45-year-old client inherits \$2 million and wishes to retire at 60, plans to buy a \$500,000 second home in 3 years, and expects significant medical expenses in 15 years. She has a moderate tolerance for risk and no significant legal constraints.

**Question:**  
Briefly outline an appropriate strategic asset allocation approach.

> **Answer:**

- Estimate cash flows: \$500,000 outflow in 3 years (liquidity need); medical expenses in 15 years (liquidity/time horizon).
- Determine required portfolio return to meet objectives, considering risk tolerance.
- Choose a diversified allocation (e.g., equities, fixed income, and cash) which balances expected return with risk profile.
- Set a higher allocation to short/intermediate-term bonds and cash to cover the home purchase.
- Ensure the IPS notes medical/emergency liquidity needs and sets constraints on illiquid or high-volatility assets.

### **Exam Warning**

> Failing to distinguish between "risk tolerance" and "risk capacity" is a common exam weakness. Do not recommend an aggressive allocation if the client lacks the financial resources to sustain major losses, even if the subjective risk tolerance appears high.

### RECOMMENDATIONS AND COMMON PITFALLS

- Avoid ambiguous language—always turn client statements into concrete objectives or constraints.
- Never ignore near-term spending needs or unique client preferences (e.g., ESG, legacy holdings, concentration risk).
- Check all legal and tax issues, especially for cross-border clients.

## **Summary**

A well-formulated individual IPS articulates precise investment objectives, clearly enumerated constraints, and an appropriate long-term risk and return profile. All recommendations for strategic asset allocation must link directly to the client's goals, capacity, and documented constraints.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and integrate client objectives and constraints for an IPS
- Distinguish between risk tolerance, risk capacity, and risk perception
- List and explain all key constraint types (liquidity, time horizon, tax, legal, unique)
- Translate IPS factors into a justified strategic asset allocation
- Apply the IPS process using robust, CFA-style workflow (cash flow mapping, scenario analysis)
- Identify common exam errors (e.g., conflating risk tolerance and capacity, missing unique constraints)

## **Key Terms and Concepts**

- Investment Policy Statement (IPS)
- Strategic asset allocation
- Risk tolerance
- Risk capacity
- Constraint

Individual IPS formulation - Strategic asset allocation for private clients