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To order reprints of any article in its original format, visit Scoopreprintsource.com Risk and Asset Allocation in Investment PoliciesASSOCIATION MANAGEMENT, May 2003The development and maintenance of a well-constructed investment policy statement is among the most important fiduciary responsibilities of an association's board and staff. When developed thoughtfully, and communicated to all relevant parties, the investment policy statement goes a long way toward managing investment risk and avoiding investment disasters long before they creep up. While a qualified financial adviser can assist you in developing your own guidelines through the use of surveys and assessments, following are some suggestions to keep in mind in determining two of the most important parts of the investment policy: your risk tolerance and, based on that, your asset allocation strategy. Identifying tolerance levels As with personal investors, associations must make investment choices based on the knowledge that the higher rates of return generally mean higher risk. Thus, it is important to establish your risk tolerance before selecting specific investment instruments. In fact, the decision regarding risk tolerance is one of the most important investment decisions an association can make. An organization needs to consider various factors in order to make sound risk tolerance decisions.Consider revenues. It is important to view the risk decision within the context of the overall fiscal health of the organization. For those associations that enjoy varied and stable sources of revenue and have regular budget surpluses, the tolerance for volatility is higher than for associations in different circumstances. Know your reserve fund's purpose. Some organizations might use their investment income as an operating budget revenue line item. Therefore, they would be unable to tolerate high-risk investments, as the budget could not handle such volatility and would have a lower risk tolerance. Others might not touch their funds unless a true emergency arose; they would have a higher tolerance for volatility. Envision worst-case scenarios. In setting appropriate risk levels, I recommend that association decision makers consider hypothetical scenarios using the organization's asset levels, thinking in terms of actual dollar losses in addition to percentage losses. When evaluating the risk tolerance for, say, a $1 million reserve fund, a 15-percent loss in value may not sound terribly harmful to some ears, but a $150,000 loss may conjure up images of dues increases, discontinued programs, or staff layoffs. Pinpointing targets Once the overall risk tolerance has been established, asset allocation can be considered. The policy must clearly state minimum and maximum levels that bracket the asset allocation targets. The challenge in defining target ranges is to make the guidelines restrictive enough to ensure that the portfolio is reflective of board-mandated risk and return characteristics, but not so strict as to create oversight burden. Well-conceived policy guidelines will more effectively guide expectations of investment performance and also provide a blueprint for portfolio rebalancing. An association might be tempted to write investment guidelines with overly broad target weight ranges. Take, for example, guidelines that allow for the following ranges: Equities 30-70 Percent Fixed income 20-60 Percent Cash 0-50 Percent Such an asset allocation may appear reasonabl--untill one considers the wide range of possible portfolio structures under these guidelines and the correspondingly wide range of allocation outcomes. With these broad ranges, actual asset allocation could range from approaches considered quite conservative to those that are quite aggressive, suggesting that the leadership creating such guidelines are not adequately meeting their fiduciary responsibility. To determine an acceptable range, first set specific targets, such as 50 percent for equities 40 percent for fixed income, and 10 percent for cash. You can then establish ranges by following the general guideline that they should not exceed 20 percent of the specified target in either direction. Thus, for the preceding targets, ranges would be as follows: Equity 40-60 Percent Fixed income 32-48 Percent Cash 8-12 Percent Understanding your policy's importance Organizations that are struggling with volatile financial markets will be well served by creating investment policies that reflect their tolerance for risk long before the risk manifests itself in a bear market. This strategy does not imply an ability to avoid a down market altogether, but rather to limit exposure to volatile asset classes to a tolerable level while at the same time maintaining consistency with the organization's return expectations. James K. Meek is first vice president, investments, Legg Mason, Inc., Baltimore. E-mail: jkmeek@leggmason.com.
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