Portfolio Design: A Modern Approach to Asset Allocation

VOLATILITY AND UNCERTAINTY

The returns just cited are average real returns. It’s important to assess the impact of the volatility of these returns. You can drown in a pond with an average depth of three feet. Consider the case of the S&P 500 from 1951 to 2009. The standard deviation of the S&P 500 expressed in annual terms was 14.6 percent, while the real compound return was 6.7 percent. Suppose that a foundation sets spending at the expected real return of 6.7 percent. Figure 14.1 shows how a $10 million portfolio grows over 20 years if invested in the S&P’s real return and if spending is maintained at that same real return. The cases shown are those where actual returns are equal to 6.7 percent and where actual returns are one standard deviation above or below 6.7 percent. If average real returns are equal to the spending rate, the foundation keeps the original portfolio intact in real terms over the 20-year period studied. The portfolio has grown in nominal terms with the cost of living, but the real value of the portfolio remains at $10 million. If average real returns are one standard deviation below 6.7 percent, the $10 million portfolio shrinks almost to $1 million over 20 years.

The situation may be even worse than pictured because the timing of the returns matters. Bad returns may occur early in the investment horizon. A bear market like that experienced in 2001 and 2002 or 2008 and 2009 can cripple a foundation’s spending plan. To take into account such bad scenarios, ...