CFA Level I Exam · Basics of Portfolio Planning and Construction

Investment Policy Statement (IPS): Meaning, Components and Exam Approach

Updated 7 October 2026 · Fact-checked

An investment policy statement (IPS) is a written document that sets out a client's objectives and constraints and guides the portfolio manager's decisions. It has return and risk objectives plus five constraints: liquidity, time horizon, tax, legal and regulatory, and unique circumstances. To answer questions, classify each fact into one of these components.

Understand Investment Policy Statement (IPS)

An investment policy statement (IPS) is the written plan between a client and a portfolio manager. It is the first output of the planning step in the portfolio management process. It records what the client wants, what the client can tolerate and what limits apply. Every later decision, such as asset allocation and security selection, is judged against it.

The IPS has several purposes. It forces the client and manager to think clearly about goals. It sets realistic expectations. It gives the manager a benchmark for judging performance. It protects both sides: the client knows what to expect, and the manager has a clear mandate. It also reduces the chance of emotional decisions during market stress, because the agreed rules are written down.

The main components are: a client description, the purpose of the document, the duties and responsibilities of the parties, the investment objectives (return and risk), the investment constraints, and the investment guidelines (such as permitted assets, leverage and ESG rules). A good IPS also covers the review schedule, rebalancing policy, performance evaluation (the benchmark) and the procedure for updating it.

Objectives are what the client wants. The return objective can be absolute (for example, 6% a year) or relative (beat a benchmark), and may be stated as a required return or a desired return. The risk objective combines ability to take risk (driven by wealth, time horizon, liquidity needs and income stability) and willingness to take risk (the client's attitude). If the two differ, the lower one usually governs, so the portfolio is not riskier than the client can bear or accept.

Constraints are the limits on how the portfolio can be run. There are five: liquidity (cash needs for spending, emergencies or liabilities), time horizon (the period until funds are needed, which may have several stages), tax (the client's tax status and how returns are taxed), legal and regulatory (laws, trust rules and regulations that restrict investing) and unique circumstances (anything else, such as ESG preferences, concentrated holdings or restrictions on certain securities). Roles matter too: the client provides information and approves the IPS, and the manager builds the portfolio within the IPS and reviews it regularly.

Key formulas to remember

Components of an IPS: IPS = Objectives (return, risk) + Constraints (liquidity, time horizon, tax, legal/regulatory, unique circumstances) + Guidelines; Objectives say what the client wants. Constraints say what limits the portfolio.
Risk tolerance rule: Overall risk tolerance = lower of (ability to take risk, willingness to take risk); Use this as the standard approach when the two conflict. It is a conservative convention, not a mathematical law.
Return objective types: Absolute return (a stated % or amount) vs Relative return (a stated margin over a benchmark); Required return is what is needed to meet goals. Desired return is what the client would like in addition.
Constraint memory aid: LTTLU = Liquidity, Time horizon, Tax, Legal/regulatory, Unique circumstances; Check each fact in a question against these five labels.

How to solve Investment Policy Statement (IPS) questions

Most IPS questions give you a client scenario and ask you to classify a fact, identify a missing component, or judge whether the IPS or portfolio fits the client. Use the same method each time.

1Read the question stem and note exactly what it asks: component, purpose, role or fit.
2Underline the client facts in the stem: age, income, spending needs, tax status, rules, preferences.
3Label each fact as objective (return or risk) or as one of the five constraints.
4For risk, separate ability (wealth, horizon, income stability, liquidity) from willingness (attitude, comfort with loss).
5If ability and willingness differ, take the lower one as the guide for the risk objective.
6Check whether the fact is a constraint or a guideline. Constraints are limits from the client's situation or the law. Guidelines are rules written into the IPS.
7Compare the three options and eliminate the two that mislabel the fact or break the IPS.
8Choose the option that matches the label and the client's situation.

Quickest way: Label, then eliminate

When to use it: Use for any standalone IPS question where you have about 90 seconds.

Find the single key fact in the stem and label it with one of: return, risk, liquidity, time horizon, tax, legal/regulatory, unique.
Spot trigger words: 'needs cash in' means liquidity; 'until retirement' means time horizon; 'tax rate' means tax; 'regulation' or 'trust law' means legal; 'prefers', 'excludes', 'concentrated holding' means unique.
Drop any option that uses a different label or confuses ability with willingness.
If still unsure, choose the more conservative answer on risk.

Common mistakes in Investment Policy Statement (IPS)

Treating time horizon and liquidity as the same constraint.
Both relate to when money is needed.
Fix: Liquidity is the need for cash, often at short notice or in amounts. Time horizon is the length of the investment period. A long horizon can still carry a large near-term cash need.
Using willingness to take risk when it is higher than ability.
Students take the client's stated attitude at face value.
Fix: Take the lower of the two. A bold client with a small cushion and near-term needs should have a lower risk objective.
Placing ESG or personal exclusions under legal and regulatory.
Both seem like rules the portfolio must follow.
Fix: Legal and regulatory constraints come from laws and regulation. Client preferences, such as excluding sectors, are unique circumstances.
Confusing objectives with constraints.
Both appear in the same document and sound like requirements.
Fix: Objectives are goals: return and risk. Constraints are limits: the five factors. A required return is an objective, not a constraint.
Thinking the IPS is a one-time document.
It is written at the start of the relationship.
Fix: The IPS is reviewed regularly and when the client's circumstances change, for example a new job, inheritance or change in tax or law.
Assuming the IPS guarantees returns or that the manager alone writes it.
Students focus on the manager's role.
Fix: The IPS sets expectations, not guarantees. It is prepared with the client's input and approval, and the manager implements it.

Worked examples

Example 1

A client, aged 35, plans to buy a home in two years and needs a ₹40,00,000 down payment from the portfolio. She says she is comfortable with large market swings. Which is the best description of the client's situation for the IPS? A. Her risk objective should be high because her willingness is high. B. Her ability to take risk is low because of the near-term liquidity need, so overall risk tolerance should be below her willingness. C. Her time horizon is long because she is 35, so liquidity is not a concern.

Show the solution

Identify the key facts: a large cash need in two years, and a high stated willingness to take risk.
The cash need is a liquidity and short time horizon matter, which lowers ability to take risk for at least this portion.
Ability is lower than willingness, so overall risk tolerance follows the lower one.
Option A ignores ability. Option C confuses age with the horizon for the funds needed.
Option B matches the rule.

Answer: B

Example 2

A foundation's trust deed prohibits investing in tobacco companies and requires that no more than 10% of assets be held in any single issuer. The IPS should record the tobacco ban and the issuer limit as: A. unique circumstances for both. B. legal and regulatory constraints for both, if they arise from the trust deed or applicable law. C. return objectives.

Show the solution

Identify the source of each rule: the trust deed, a legal document that binds the trustees.
Rules imposed by law, regulation or legal instruments such as trust deeds are legal and regulatory constraints.
If the ban were only the foundation's own preference, it would be a unique circumstance, but here it comes from the trust deed.
Return objectives concern required or desired returns, so option C is wrong.
Option A would be right only for preferences not backed by law or legal documents.

Answer: B

Exam tips

Expect scenario questions that ask you to classify a fact. Practise labelling facts quickly with the five constraints.
Remember the ability versus willingness rule. It is a favourite test point, and the lower of the two is the standard answer.
Watch for time horizon wording such as multi-stage horizons, where one client has near-term and long-term needs.
Read the purpose and roles questions carefully: the IPS guides the manager, is agreed with the client and is reviewed periodically. Eliminate options that call it a guarantee or a fixed document.
Because there is no penalty for wrong answers, always answer. Eliminate the two options that mislabel the facts and pick the remaining one.

Practice questions from Basics of Portfolio Planning and Construction

Investment Policy Statement (IPS) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Investment Policy Statement (IPS): frequently asked questions

What are the main components of an IPS?

An IPS typically includes a client description, purpose, roles and responsibilities, return and risk objectives, constraints, investment guidelines, and review and performance evaluation procedures. For the exam, focus most on objectives and the five constraints.

What are the five IPS constraints?

They are liquidity, time horizon, tax, legal and regulatory, and unique circumstances. Use the label to classify each client fact in a question.

What is the difference between ability and willingness to take risk?

Ability is the client's financial capacity to bear losses, based on wealth, income, horizon and liquidity needs. Willingness is the client's psychological comfort with risk. When they differ, the lower of the two usually guides the risk objective.

Who is responsible for the IPS, the client or the manager?

Both play a part. The client supplies accurate information and approves the document, and the portfolio manager helps prepare it, follows it and reviews it regularly with the client.