For the last seventeen years I have served on the board and/or finance committee of a local non-profit organization. The message below was an email I sent in response to a recent meeting where the topic of the investment performance was discussed. The points in the message apply to retirement investors just as much as they do to charitable endowment or foundation investors…
This absurdly long email is in response to the discussion we had on Tuesday regarding the recent performance of the endowment. There was frustration expressed over the meager amount of growth over the last twelve months. I’m very much in support of the decision to review our strategy in the July meeting and the follow-up discussion with [investment advisor] in August. But before those meetings, there are a few things we should consider.
Tweaking Of Allocations Is Pointless
Finding the perfect mix of foreign and domestic stocks, bonds, real estate and commodities is not only impossible, it’s actually not that important.
Below is some data taken from Mebane Faber’s new book Global Asset Allocation (yes, it’s as thrilling as the title suggests). The table shows the asset allocations of eight different portfolios. A couple are commonly used approaches, the others have been suggested by highly regarded investors like Warren Buffett, Mohammed El-Erian, and Rob Arnott. These are meant to be a mix of assets that one could use for a lifetime, in all conditions. The idea is that you would invest according to these allocations and then, once per year, you’d rebalance to bring the allocations back to the target amounts.
The interesting result is that while these portfolios recommend a wide range of allocations, over a long period of time their performance would have been strikingly similar.
This isn’t meant to suggest that an investor can slap together random selections of investments and it will just automatically work out well. It means that disciplined adherence to a plan that provides some basic things – exposure to growth markets and diversification of risk – is more important than the precise way a portfolio is carved up.
Instead of making adjustments out of frustration, we should take a very long term view of our investment approach and focus short-term management efforts on things like controlling expenses and guarding against unnecessary risk.
Performance Chasing Leads To Disaster
Pursuing the currently hot investment class is probably the most common and harmful mistake that investors make. Over the last twelve months the flat return of the endowment is frustrating because we lagged the performance of the stock market. Our diversified portfolio is the main culprit. Looking specifically at our asset classes over the last year, while domestic stocks did well, real estate and bonds were barely positive, foreign stocks were down and commodities were obliterated.
But if this suggests that we should concentrate more of our assets in domestic stocks, what does the last fifteen years tell us?
Over this longer period of recent history, real estate and bonds both significantly outperformed domestic stocks. Look a little closer at this chart and you can see long periods of time where each asset class has been either a comparative star or a dud. With that in mind, ask yourself:
- Is it reasonable to assume that any one of these classes has the potential to outperform the rest in any given year?
- Is it reasonable to assume that this potential outperformance could be significant?
- Is it reasonable to assume that this outperformance could potentially be sustained for a long period of time?
- Is it possible for us to know in advance when these periods of potential outperformance will begin, how long they will last, and the magnitude of the difference?
So that’s three yes answers and a no. The takeaway here is that we have short memories. Our basic human nature leads us to place a lot more importance on recent events than they deserve.
The Endowment Has A Distinct Purpose
The [organization] did not establish the endowment as an investment fund. The job of the endowment is to support the mission of the [organization]. We invest the money to combat inflation and spending and to aid in the growth of the endowment, but the investments are not the purpose, they’re just tools – a means to an end.
This pool of money is intended to outlive all of us. We are, and should be, growth investors and we shouldn’t become overly concerned by the natural fluctuation in performance that is the unavoidable consequence of being a growth investor. However, the endowment still needs to be able to carry out the job it was designed to do.
If we invest the same way most of our donors invest, the endowment’s ability to perform its job will be at its worst at the exact moment it’s needed the most. When markets fall and the economy slows and donations dwindle, that’s when the endowment has to be able to provide support. Today our biggest problem is figuring out how to deal with all this damn cash that is piling up everywhere. But bigger challenges will come again and that’s why we are diversified among a variety of both markets and strategies.
Beyond the occasional big market gyration, it’s also important that we be realistic about returns over longer periods. Looking deeper into the Mebane Faber research noted above, most of the portfolios would have produced negative real returns for the entire decade of the 1970s (real return is the nominal return minus inflation). With all those pleasant forty year average numbers listed in that table, it’s easy to overlook a stretch like this, but in real time, we all know that there would be a lot of angst during committee and board meetings. Hopefully, when the time comes, we will remember that it’s discipline during rough patches that make the better periods possible.
By the same token, it’s discipline during good times that makes surviving bad periods possible.
For what it’s worth, I will have one recommendation for the committee during the July meeting.
I’m going to propose that [details pertaining to organization business].
Moral of the story: Coming up with a good investment plan is easy. Discipline is hard.
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The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated.
The Morningstar US Real Asset Index represents the performance of liquid “real assets” – 40% Treasury Inflated Protected Securities ‘TIPS,’ Morningstar US TIPS Index), 30% commodity futures (Morningstar Long/Short Commodity Index), 15% REITs (Morningstar US REIT Index Index) and 15% commodity related equities (10%Global Upstream Natural Resources Index/5% Morningstar MLP Composite Index).
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