subject: THE SPECIFICATION OF INVESTMENT POLICY [print this page] THE SPECIFICATION OF INVESTMENT POLICY THE SPECIFICATION OF INVESTMENT POLICY
THE SPECIFICATION OF INVESTMENT POLICY
Investment counsellors and trustees do not ignore the choice ofinvestment policy. In fact, they typically produce a written statementof policy and occasionally refer to it. Current practice deserves criti cism not only because of the casual, intuitive process by which policyis chosen, but also because of the ambiguity and vagueness of its expression. These deficiencies are often so pronounced that the policyneither provides meaningful guidance to the portfolio manager northe effective means for controlling him and evaluating hisperformance.
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Many trust departments and investment counselling firms rely onthree criteria to give operational meaning to statements of policy :
1.A list of securities eligible for purchasethe so-called "buy" list.
2.A diversification requirement, usually specifying the maximum
percentage of a portfolio that can be invested in the securities
of a single company and the maximum percentage that can be
invested in a single industry.
3.A maximum percentage that can be invested in equities.
These three criteria are designed to restrict investments to undervalued securities, to control risk through diversification and a maximum commitment to equities, and to deal with the timing problemby changing the maximum permissible commitment to equities. Although there is remarkably little evidence that "buy lists" outperform other securities of similar risk, the three criteria combined do provide some control over portfolio managers.
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Yet, the control is crude and inexact. Portfolios can be and areconstructed from the same "buy list," with the same percentage in equities and full compliance with the criteria for diversification, and yet have quite different characteristics. More than one trust department and investment counselling firm foresaw the 196970 bear mar ket and sought unsuccessfully to effect appropriate modifications in portfolios through changes in "buy lists" and reductions in maximum,permissible levels of investment in equities. The control mechanismfrequently failed, if portfolio managers, not sharing the pessimism oftheir policy makers, shifted to equities more sensitive to market movements than those previously held. Reducing the proportion of a portfolio in equities from 80 percent to 60 percent will not make theportfolio less vulnerable to a market decline, if the equities held havesubstantially higher beta coefficients than those formerly held.
A more precise prescription of policy could be achieved throughthe use of beta coefficients and correlation coefficients. The prescrip tion of a beta coefficient would perform two functions. It would control the relative riskiness of all portfolios and would permit a controlledadjustment in absolute levels of systematic risk in response to convictions of policy makers regarding future, major market movements.The prescription of a correlation coefficient would control diversification and thus the proportions of total risk that would be unsystematicthat is, caused by something other than movements in themarket. A "buy list" can also be used, but its value should be frequently tested.
