In this series, we arelooking at the steps of a traditional investment management process and demonstrating how a principles-based fiduciary standard can be incorporated into them. Last month, we examined the second step of the process: Strategize. This month, we move on to the third: Formalize.

In this step, we will develop an asset allocation and investment strategy that represents the greatest probability of achieving the client's goals and objectives. It will also be consistent with the client's unique risk/return profile and with our own implementation and monitoring constraints. We will then use these inputs to prepare the client's investment policy statement (IPS).

CONSISTENT WITH RATE

In the second step, we used the acronym RATE (Risk tolerance, Asset-class preferences, Time horizons and Expected outcomes) to define the inputs you can use to develop the client's optimal asset allocation strategy. Most practitioners agree that the client's asset allocation will have more impact on long-term investment performance than any other factor. Therefore, we must devote considerable attention to how we determine asset allocation and ensure it is aligned with the RATEs the client identified in Step 2.

Most asset allocation strategies are developed from software, which depends on the modeled risk of each asset class, the modeled-or expected-return of each asset class and the correlation of each asset class to the others. As a fiduciary, it's your responsibility to ensure that these expected or modeled inputs are reasonable and based on generally accepted investment theory. While no one expects you to be able to forecast future returns, as a fiduciary, you do have a duty to demonstrate that the asset allocation strategy was based on a procedurally prudent process.

In developing capital markets inputs for asset allocation software, experience suggests that historical data on different asset classes is useful in developing standard deviation estimates. However, according to economist William Sharpe, such data has proved only "reasonably useful for correlations and virtually useless for expected returns." Historical data is not only likely to provide poor estimates of future performance, but could also lead to developing expectations that cannot be met.

Advisors often make mistakes when developing an asset allocation strategy. Here are some of the most common slip-ups I've seen advisors make:

* Implying to the client that there is a level of precision or confidence to the asset allocation process. The output is a model for planning purposes-nothing more. Once the critical allocations have been made between equity, fixed income and cash, the allocation to additional asset classes often can be determined with common sense through an intuitive process. Despite advances in portfolio modeling, not all asset allocation decisions have been reduced to a computerized solution.

* Not involving the client in the asset allocation discussion. If the client isn't fully engaged in the process, it's likely that he or she will bolt at the first sign of market volatility.

* Under-allocating. Making an allocation of less than 5% to an asset class rarely makes good sense. It probably won't materially change the risk/return profile of the overall portfolio, and it will be costly-both in terms of implementation and monitoring.

USING CONSTRAINT

Next, the proposed asset allocation strategy-and supporting investment strategy-must be carefully evaluated to determine whether it can be prudently implemented (discussed in more detail in Step 4) and then effectively and efficiently monitored (discussed in more detail in Step 5). One classic problem that occurs is an allocation to alternative investments. Due to a lack of transparency and the complexity of many of the structured financial instruments available today, advisors may have difficulty employing the same level of due diligence as they could apply to a mutual fund or a separate account manager. A good rule of thumb: If you lack the time, inclination or knowledge to conduct appropriate due diligence-be it of an asset class or an investment manager-stay clear of the strategy or the manager.

It's also important that you demonstrate procedural prudence in the process you follow to manage your client's investment decisions. Most investments-or investment strategies-aren't imprudent on their face. It's the way they're used-and how decisions regarding their use are made-that will be examined to determine whether the prudence test has been met and if you have truly acted as a fiduciary.

Even the most aggressive and unconventional investment strategy can meet a fiduciary standard if you have used a sound process to develop it. Likewise, even the most conservative strategy may not measure up if a sound process is lacking.