The Investment Risk Policy

A good investment risk policy can save you from making a quick, but bad, decision.

Every company needs an investment risk policy. It doesn't matter how small your company is, at some point you will be faced with a decision regarding what to do with extra company cash or, better yet, how to convert profits into growth assets such as machinery, facilities, employees or acquisitions of other companies. When these decisions arise, without a well-constructed investment policy in place, you are likely to respond to the hottest idea that walks through the door -- and that is often not your best choice.

Investment Risk

There are four basic forms of investment risk: credit, interest rate, market and liquidity. Credit risk involves current financial health and the possibility that it will decline to bankruptcy levels over time. Interest rate risk involves the cost of money and how it will affect your bottom line if borrowing becomes too expensive. It also includes inflation risk since the Federal Reserve raises interest rates to cool down a booming economy as a means of forestalling inflation. Market risk affects the valuation of your company and its assets, and fluctuates according to economic conditions and events such as geopolitical strife and natural disasters. Liquidity risk affects your ability to make buy-sell decisions when there are no active markets.

Forming a Policy

The chief financial officer, chief executive and board of directors set investment policy, which the chief financial officer implements. Creating an investment policy before it is needed is likely to result in a better, more conservative set of guidelines. It should cover what to do with daily cash, excess short-term cash, accumulated long-term cash and liquid and illiquid assets. All investment policies should follow the Prudent Man Rule, which directs fiduciaries "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested."

Writing it Down

Your investment choice for daily cash is generally a checking account, interest-bearing checking account or money market account at a bank or broker-dealer. Short-term excess cash can be invested in a money market account, FDIC- insured certificates of deposit, U.S. Treasury bills and investment grade commercial paper and corporate notes. Investment grade refers to credit ratings of Baa at the lowest to AAA at the highest. All daily and short-term cash should be invested primarily to protect the principal and achieve a reasonable return. With long-term cash, you get into determination of risk tolerance relative to return. If you are accumulating cash for a future expansion or acquisition, your goal should be safety of principal. If you are considering investment in a corporate acquisition, facilities, equipment, personnel, intellectual property or other corporate assets, your decision should be based on the current value of the asset, future value of the asset or its value in terms of corporate growth, an estimate of how likely it is that value will be achieved and the downside of its purchase. The key is deciding whether the asset considered for investment is worth losing the use of the cash.

Implementation

Your written investment policy is useless if not followed. Your company is constantly faced with an onslaught of professional service providers who are trying to separate you from your money. Your investment policy is intended to serve as your money diet plan, telling you not to eat the chocolate cake no matter how appealing it is at the moment. The greatest risk your company faces is the loss of opportunity as a result of succumbing to a too-risky investment that loses all your cash reserve.

References

• CalPERS: Investment & Risk Management Policies
• FDIC: Trust Examination Manual