A worrying trend that has emerged recently among financial planners is the swearing by rigid asset-allocation models, called policy portfolios. It has attained a fervency, crudely akin to religious beliefs. To the beginner, policy portfolio is an investment portfolio with asset classes (such as equities, debt, gold etc) following a steady, long-term portfolio weight. Economic perspectives take back seat to statistical infatuation.
Contrarily, evaluating your investment decisions and investment portfolio from economic outlook and reasoning perspective is critical. Such an approach can hedge extreme outcomes.
Investment opportunities reflect current economic realities and therefore subject to change with the times. Therefore, a solution arrived initially, not only needs review later to account changed economic pattern, it must be studied at the outset with economic realities before you call it a valid investment solution.
Policy portfolios come in various appellations such as conservative, moderate, or aggressive. Despite the persuasive messaging through captions, these are dependent on model-synthesis that rest on several tenuous statistical assumptions. For instance, random-walk hypothesis forms the basis for widely used fixed asset-allocation recommendations. These models assume stationarity in a real world, which is patently inconsistent.
Merits of hyper-specialized financial and economic streams deserve a separate discussion. What we need to agree on is these models jettison truth and reality in favor of passing empirical testing under assumptions criteria. The narrow purpose of model validity is more important to the model creators than any reference to reality.
Financial planners and advisers are increasingly adopting institution type models and force-fitting them to individual investment portfolios. Rarely do the objectives of these two investment clients meet. In the desire to appear sophisticated individual investment portfolios are being put to serious risks.
Researchers, instead of confessing about the paucity of tool-kits, have been under a spell of ‘extend and pretend’ that it is very often said in the context of monetary policy authorities. Instead of letting go normal distribution, we now have fat-tails, kurtosis, skewness and similar tools which claim to represent the actual market price pattern, when in fact, they hardly do.
This is not to make a case against investment policy in general. But, against nonsensical portfolio weights built on tenuous assumptions. And more importantly – on assumptions and inconsistencies that we don’t know that exist in the first place. Most advisors have never been exposed to the full chain of research papers (that give final validity to policy portfolio), nor have they parsed through the inconsistent and sometimes clandestine assumptions that get carried over from one to another.
An investment policy would serve well to capture client specific characteristics (such as time horizon, liquidity needs etc) and reflect economic outlook including geopolitical realities.