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An investment manager is very unlikely to produce a good result for a client without understanding that client's needs, circumstances, and constraints.

A written investment policy statement will typically begin with the investor's goals in terms of risk and return. These should be determined jointly, as the goals of high returns and low risk (while quite popular) are likely to be mutually exclusive in practice. Investor expectations in terms of returns must be compatible with the investor's tolerance for risk (uncertainty about portfolio performance).

The major components of an IPS typically address the following:

• Description of Client — circumstances, situation, and investment objectives.
• Statement of Purpose of the IPS.
• Statement of Duties and Responsibilities of investment manager, custodian of assets, and the client.
• Procedures to update the IPS and to respond to various possible situations.
• Investment Objectives derived from communications with the client.
• Investment Constraints that must be considered in the plan.
• Investment Guidelines such as how the policy will be executed, asset types permitted, and leverage to be used.
• Evaluation of Performance — the benchmark portfolio for evaluating investment performance, and other information on evaluation of investment results.
• Appendices containing information on strategic (baseline) asset allocation and permitted deviations from policy portfolio allocations, as well as how and when the portfolio allocations should be rebalanced.

In any case, the IPS will, at a minimum, contain a clear statement of client circumstances and constraints, an investment strategy based on these, and some benchmark against which to evaluate the account performance.

The risk objectives in an IPS may take several forms. An absolute risk objective might be to "have no decrease in portfolio value during any 12-month period" or to "not decrease in value by more than 2% at any point over any 12-month period." Low absolute percentage risk objectives such as these may result in portfolios made up of securities that offer guaranteed returns (e.g., U.S. Treasury bills).

Absolute risk objectives can also be stated in terms of the probability of specific portfolio results, either percentage losses or dollar losses, rather than strict limits on portfolio results. Examples are:

• "No greater than a 5% probability of returns below −5% in any 12-month period."
• "No greater than a 4% probability of a loss of more than $20,000 over any 12-month period."

An absolute return objective may be stated in nominal terms, such as "an overall return of at least 6% per annum," or in real terms, such as "a return of 3% more than the annual inflation rate each year."

Relative risk objectives relate to a specific benchmark and can also be strict, such as, "Returns will not be less than 12-month euro LIBOR over any 12-month period," or stated in terms of probability, such as, "No greater than a 5% probability of returns more than 4% below the return on the MSCI World Index over any 12-month period."

Return objectives can be relative to a benchmark portfolio return, such as, "Exceed the return on the S&P 500 Index by 2% per annum." For a bank, the return objective may be relative to the bank's cost of funds (deposit rate). While it is possible for an institution to use returns on peer portfolios (such as an endowment with a stated objective to be in the top quartile of endowment fund returns), peer performance benchmarks suffer from not being investable portfolios — there is no way to match this investment return by portfolio construction before the fact.

In any event, the account manager must make sure that the stated risk and return objectives are compatible, given the reality of expected investment results and uncertainty over time.

An investor's ability to bear risk depends on financial circumstances. Longer investment horizons (20 years rather than 2 years), greater assets versus liabilities (more wealth), more insurance against unexpected occurrences, and a secure job all suggest a greater ability to bear investment risk in terms of uncertainty about periodic investment performance.

An investor's willingness to bear risk is based primarily on the investor's attitudes and beliefs about investments (various asset types). The assessment of an investor's attitude about risk is quite subjective and is sometimes done with a short questionnaire that attempts to categorize the investor's risk aversion or risk tolerance.

When the adviser's assessments of an investor's ability and willingness to take investment risk are compatible, there is no real problem selecting an appropriate level of investment risk. If the investor's willingness to take on investment risk is high but the investor's ability to take on risk is low, the low ability to take on investment risk will prevail in the adviser's assessment.

In situations where ability is high but willingness is low, the adviser may attempt to educate the investor about investment risk and correct any misconceptions that may be contributing to the low stated willingness. However, the adviser's job is not to change the investor's personality characteristics that contribute to a low willingness to take on investment risk. The approach will most likely be to conform to the lower of the investor's ability or willingness to bear risk, as constructing a portfolio with a level of risk that the client is clearly uncomfortable with will not likely lead to a good outcome.

Investment constraints include the investor's liquidity needs, time horizon, tax considerations, legal and regulatory constraints, and unique needs and preferences.

Liquidity: Liquidity refers to the ability to turn investment assets into spendable cash in a short period of time without having to make significant price concessions to do so. Investor needs for money to pay tuition, to pay for a parent's assisted living expenses, or to fund other possible spending needs may all require that some liquid assets be held. Property and casualty insurance companies, for example, must hold a significant proportion of liquid (or maturing) securities to be prepared for unpredictable claims. Illiquid investments in hedge funds and private equity funds, which typically are not traded and have restrictions on redemptions, are not suitable for an investor who may unexpectedly need access to the funds.

Time horizon: In general, the longer an investor's time horizon, the more risk and less liquidity the investor can accept in the portfolio. While the expected returns on a broad equities portfolio may not be too risky for an investor with a 20-year horizon, they are likely too risky for an investor who must fund a large purchase at the end of this year. For such an investor, government securities or a bank certificate of deposit may be the most appropriate investments because of their low risk and high liquidity.

Tax situation: Besides an individual's overall tax rate, the tax treatment of various types of investment accounts is also a consideration. For a fully taxable account, investors subject to higher tax rates may prefer tax-free bonds (U.S.) to taxable bonds, or prefer equities expected to produce capital gains (often taxed at a lower rate than other types of income). A focus on expected after-tax returns over time should correctly account for differences in tax treatments as well as investors' overall tax rates.

Some investment accounts, such as retirement accounts, may be tax exempt or tax deferred. Investors with such accounts may put securities that generate fully taxed income (e.g., corporate bond interest) in tax-deferred accounts, while seeking long-term capital gains, tax-exempt interest income, and dividend income (where dividends receive preferential tax treatment) in personal taxable accounts.

Legal and regulatory: In addition to financial-market regulations applicable to all investors, more specific legal and regulatory constraints may apply to particular investors. Trust, corporate, and qualified investment accounts may all be restricted by law from investing in particular securities and assets, or face percentage-allocation limits. Corporate officers and directors face legal restrictions on trading in their firms' securities that the account manager should be aware of.

Unique circumstances: Each investor may have specific preferences or restrictions on which securities and assets may be purchased. Some are nonfinancial considerations, commonly categorized as responsible investing: ethical preferences (e.g., prohibiting tobacco or firearms producers), human-rights-related restrictions (companies or countries with documented abuses), or religious preferences (e.g., precluding investment in securities that make explicit interest payments). Unique investor preferences may also reflect diversification needs when the investor's income depends heavily on the prospects for one company or industry — an investor who has founded or runs a company may not want any investment in securities issued by a competitor.

After determining investor objectives and constraints through the IPS, a strategic asset allocation is developed which specifies the percentage allocations to the included asset classes. In choosing which asset classes to consider, the correlations of returns within an asset class should be relatively high (assets within the class are similar in performance), while correlations of returns between asset classes should be relatively low (this is what leads to risk reduction through portfolio diversification).

Historically, only the broad categories of equities, bonds, cash, and real estate were considered. More recently, a group of investable asset classes referred to collectively as alternative investments has gained prominence: hedge funds of various types, private equity funds, managed or passively constructed commodity funds, artwork, and intellectual property rights.

We can further divide equities by whether issuing companies are domestic or foreign, large or small, or whether they are traded in emerging or developed markets. A U.S. investor may want to divide world equities into different regions. Bonds can be divided based on maturities or on criteria such as foreign vs. domestic, government vs. corporate, or investment grade vs. speculative (high-yield). Overall, the asset classes considered should approximate the universe of permissible investments specified in the IPS.

Once the universe of asset classes has been specified, the investment manager will collect data on the returns, standard deviation of returns, and correlations of returns with those of other asset classes for each asset class.

Once the portfolio manager has identified the investable asset classes and the risk, return, and correlation characteristics of each, an efficient frontier (analogous to one constructed from individual securities) can be built. Combining the IPS's risk/return objectives with the actual properties of portfolios along the frontier, the manager can identify the portfolio that best meets the investor's requirements. The asset allocation for that selected portfolio is the strategic asset allocation.

Deviations from strategic asset allocations or selection of individual securities within asset classes are referred to as active (versus passive) portfolio management strategies. A manager who varies from strategic weights to take advantage of perceived short-term opportunities is adding tactical asset allocation to the strategy. Security selection refers to deviations from index weights on individual securities within an asset class — for example, overweighting energy stocks and underweighting financial stocks relative to U.S. large-cap index weights. For some asset classes (hedge funds, individual real estate properties, artwork), investable indexes are not available, so selection of individual assets is required by the nature of the class.

While each active strategy may produce higher returns, they also increase risk relative to a passive portfolio of asset-class indexes. Risk budgeting sets an overall risk limit for the portfolio and budgets (allocates) a portion of permitted risk to (1) the systematic risk of the strategic asset allocation, (2) tactical asset allocation, and (3) security selection.

Two specific issues with active management:

1. An investor may have multiple managers actively managing to the same benchmark (or with significant benchmark overlap). One manager may overweight an index stock while another underweights it. Net active risk is reduced, but each manager reports active risk — the risk budget is underutilized as net active management is less than gross active management.
2. When all managers actively trade relative to indexes, excessive trading overall may result, with negative tax consequences (potentially higher capital gains taxes) compared to an overall efficient tax strategy.

One way to address these issues is the core-satellite approach: invest the majority (core) of the portfolio in passively managed indexes and a smaller (satellite) portion in active strategies. This reduces excessive trading and offsetting active positions.

The success of security selection depends on the manager's skill and the opportunities (mispricings or inefficiencies) within an asset class. The success of tactical asset allocation depends on both the existence of short-term opportunities in specific asset classes and the manager's ability to identify them.

Approaches to ESG investing include:

• Negative screening — excluding specific companies or industries based on ESG factors.
• Positive screening — investing in companies that have positive ESG practices.
• Thematic investing — selecting sectors or companies to promote specific ESG-related goals.
• Impact investing — selecting investments both to provide a return and to promote positive ESG practices.
• Engagement / active ownership — using share ownership as a platform to promote improved ESG practices at a company.
• ESG integration — considering ESG factors throughout the asset allocation and security selection process.

If a portfolio's investment universe is constrained by negative screening, measuring its performance against a broad market index is unlikely to be appropriate. Indexes excluding companies or industries that ESG-concerned investors commonly avoid are available.

For positive screening, thematic, or impact approaches, choices of which specific companies to invest in and which ESG factors to focus on differ among investors. Thus, portfolios and performance benchmarks must be customized, and they may require investment managers who specialize in these styles.

For active ownership, it is important to clarify whether clients intend to vote their shares themselves or direct managers to vote according to specified ESG factors.

Regardless of the approach chosen, imposing constraints based on ESG factors will likely affect portfolio performance — though direction is uncertain. Limiting the universe and incurring ESG-related costs may decrease returns; on the other hand, investing in companies with good corporate governance and avoiding ESG-related risks may increase returns.