Primer: What Is A Policy Portfolio?

This is a short description of what a policy portfolio is, and why you should have one for your personal investment portfolio.

A policy portfolio is a baseline or target mix of the asset classes (e.g., stocks, bonds, cash) for an investment portfolio. Institutional investors may manage their portfolios against such a target, and they are often constrained in how far their portfolios may drift from that target. If you are managing your own personal portfolio, you will have more flexibility, but using the policy portfolio concept is still a good idea.

For a personal portfolio, the usual breakdown is amongst 3 broad asset classes:

• Cash;
• Bonds;
• Equities (stocks).

A target percentage is set for each asset class. The cash component is typically small (0-10%), and the remainder divided between stocks and bonds. The usual idea is that stocks are riskier but have higher returns, and so you have a higher percentage of stocks if you are more tolerant of risk. 

The weighting that you should use depends on your personal situation, so I cannot give target levels to use. Some techniques were developed in the 1960's to come up with "optimal" portfolios based on people's risk tolerances. Although the mathematics may appear impressive, I find the theory to be somewhat of a pseudo-science. The best way would be look at how historical portfolios with the target weightings performed over time, and get a qualitative feel whether those simulated portfolios act in a way you would like. However, this requires access to data, ability to manipulate the data, and interpret the results. If you are not in a position to do such an analysis, the best bet is to not heavily overweight any asset class in particular. (If you are using automated tools to generate the weightings, for example, keep the return target reasonable. This allows the tool to give a more even weight.)

There is a wide variety of categories within these broad asset classes. If you are looking at mutual funds, there could be dozens of equity or bond funds just within the same family of funds. Although diversification is useful, the key is to work within the aggregate target. For example, if you allocate 5% of your portfolio to 20 different equity funds, your portfolio may be a lot less diversified than you think.

Within the bond component, some care should also be taken with a drift towards riskier categories of assets. For example, if the bond component is put into High Yield ("Junk") bonds, it will offer very poor diversification relative to the equity component of the portfolio. The overall weightings may need to be adjusted to compensate for such a tilt.

The policy portfolio depends on your situation, and needs to be reviewed over time. For example, a standard rule of thumb is to increase the bond weighting at the expense of the stock weighting over time. Therefore, portfolios of seniors are supposed to be bond-heavy, while young workers should have equity-heavy portfolios.

Finally, having such a policy portfolio is an important component of being disciplined. If you just buy or sell securities based on water cooler stories or what you read on some blog somewhere, your portfolio can end up being a disorganised mess, and far riskier than you think. During the Tech Equity bull market of the late 1990's, there were a lot of people that let their portfolios get heavily overweight tech stocks. Those stocks went down in flames later, and a lot of people's retirement plans were badly hurt as a result. A more balanced portfolio weighting will not have completely saved people from losses, but the damage would have been a lot less. 

(c) Brian Romanchuk 2013