Asset Allocation

CHAPTER 10Policy Portfolios

FALLACY: POLICY PORTFOLIOS MATTER

Investors often articulate a set of portfolio weights called a “policy portfolio.” It is intended to reflect one's unique circumstances and preferences, such as the desired balance between expected return and risk. It is intended to provide a stable reference point, a portfolio that reliably satisfies the investor's needs. However, fixed-weight portfolios have wildly unstable risk; thus, they fail to satisfy investor preferences through time. What investors crave is stability in performance. Allocation weights are just a means to that end. Instead of a rigid policy portfolio, we argue it is better to have a flexible portfolio policy.

RISK INSTABILITY

The purpose of investing is to grow wealth, but competitive markets do not offer free lunches; they conspire to ensure that higher expected return comes at the expense of higher risk. Investors must therefore balance two competing objectives: the desire to grow wealth and the desire to avoid loss.

It is important to understand this trade-off and to strike the right balance. It does not make sense, however, to express the solution to this trade-off as a set of “policy portfolio” weights, because risk is not constant through time. A static allocation cannot reflect an essential feature of investor preferences when the properties of the underlying assets are always changing. Figure 10.1 highlights the severity of this problem. It shows rolling three-year standard deviations ...