What is Policy Portfolio
A policy portfolio is a target mix of different asset classes. For every financial planner or investment advisor, the policy portfolio remains the cornerstone of his practice, based on which, he provide his assistance to his clients. It is a term used to describe the common practice among the financial planner or advisor, under which, he sets a fixed asset-allocation mix as a part of the investment policy. It helps him avoid timing the market.
For individual investors, the policy portfolio will base on their risk profile and age. There are broadly three asset classes, where an individual can invest. They are:
Equities (including equity MF)
Fixed income (including debt MFs and bank FDs)
Cash (including savings account balance and liquid MFs)
A target percentage is set for each of the above asset classes with a tolerance level. For example, let's say your policy portfolio layout states that you should have 60 per cent in equities, 30 per cent in fixed income and the remaining 10 per cent in cash. Apart from this, it states to what extent it can vary. So, your equities holding can go up to 65 per cent or 55 per cent. Other asset classes can also be defined in a similar way.
Even within this broader asset class, there can be sub-asset classes, where your policy portfolio can guide. For example, in equities, you can have large-cap, mid-cap, or small-cap dedicated funds. Out of a total 60 per cent of your equity allocation, 50 per cent can go to a large-cap, 40 per cent to mid-cap, and rest to small-cap.
A policy portfolio is very important for an investor to remain disciplined. Nevertheless, it does not mean that once you have a policy portfolio, you can relax and just periodical review is enough. You need to constantly keep an eye on your holdings and its performance.
This is because one of the underpinnings of the policy portfolio is that it is supported by the random-walk model, which says that the return-generating process is stable. However, things are not so in practice. The second important assumption, based on which policy portfolio is used, is that it is reinforced by efficient market theory. It means returns are unstable and are dependent upon the events as and when they occur. Even in this case, you cannot forecast mean returns and standard deviations from historical returns, which again implies that the policy portfolio cannot remain the same forever.