Designing the New Policy Portfolio: A Smart, but
Humble Approach

Abstract

Is the policy portfolio dead? Should investors replace strategic policy with tactical portfolios? These challenging questions have arisen lately as investors have suffered rare downside events and are facing a more uncertain future. In this article, Dopfel attributes the recently experienced, surprisingly wide dispersion of investment returns to the presence of economic and financial market regimes—both good and bad. A regime framework, though, presents new challenges for a strategic policy portfolio because optimal portfolios vary greatly depending on the presumed regime and its underlying investment assumptions. In this setting, the investment performances of two strategic investors—“Naïve” and “Smart, but Humble”—are compared with the performances of two tactical investors—“Myopic” and “Prophetic.” As their nicknames suggest, the hypothetical investors possess differing levels of skill in their abilities to forecast regimes. The Smart, but Humble investor provides a model for the new policy portfolio by setting a strategic policy that accounts for the additional uncertainty associated with regime shifts (i.e., smart), while declining to time the market (i.e., humble).

TOPICS: Portfolio theory, financial crises and financial market history, tail risks