Portfolio Design: A Modern Approach to Asset Allocation

USING HISTORICAL RETURNS SINCE 1951 TO SET SPENDING RULES

The first set of simulations will be based on actual historical returns on stocks and bonds since 1951. That is, the returns will be based on the 2.4 percent real return on medium-term bonds and the 6.7 percent real return on the S&P 500. Because the portfolio consists of three assets with shorter historical series, the premium method discussed above will be used to determine the returns on these three assets using the 2.4 percent and 6.7 percent real returns on the longer historical series. The expected nominal compound return on the three asset portfolio is 8.8 percent. The simulations will be done using the simulation software Zephyr AllocationADVISOR.9

The results of these simulations are shown in Figure 14.2. The spending rate of the foundation is set at rates between 3 percent and 6 percent. After a thousand simulations, the software calculates the percentage of times in which the portfolio falls below its minimum threshold of 65 percent of the initial portfolio value. This gives the failure rate for the spending rule. The lower curve in Figure 14.2 represents simulations in which the spending rule is kept proportional to the level of wealth. So a 4 percent spending rule represents $400,000 spent out of a $10 million dollar portfolio in the first year of operation. If nominal returns are 10 percent the first year, then the 4 percent spending rule will allow the foundation to spend $440,000 the second year. If nominal ...