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How can someone who fails be faulted when everyone else is failing?

Market turbulence can cause endowment fund managers to travel with the herd — sacrifice returns in order to reduce annual volatility
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Chapter 12 of John Maynard Keynes’ 1936 treatise, The General Theory of Employment, Interest and Money, is chock-full of wisdom and memorable language. One of my favorite quotations is

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

In the 1930s, Keynes (1883–1946) was writing about the scorn that long-term investors were subject to by the speculators who dominated stock trading:

It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.

These days, Keynes’ observation still applies, though the scorn comes not only from speculators but from “prudent” investment managers who use modern portfolio theory to reduce short-term fluctuations in the market value of the funds they manage.

As a college professor, I see this most often in the way colleges, universities, and other nonprofit institutions manage their endowments. Annual endowment withdrawals support the institutions’ annual operating budgets. There is an understandable desire for stability in these withdrawals.

Unfortunate consequence of stability

The unfortunate consequence is that endowment managers invest too much in bonds and other relatively stable assets even though they generate low returns. For example, many have long followed the 60/40 rule (60% stocks/40% bonds) that attempts to blend relatively high returns from stocks with the relative stability of bond prices.

The core problem with this conventional approach is that endowments are intended to last indefinitely and endowment managers should prioritize long-run performance over short-term stability. After the Yale endowment’s disappointing 1.8% return in 2023 (compared with the S&P 500’s 19.84% return), Yale’s Chief Investment Officer wrote,“As a 322-year-old institution, Yale benefits from the rare ability to invest with a truly long time horizon. Given this, we measure our success over decades, not days, months, or even years.”

That argument is persuasive but it is not consistent with the models used by Yale and other institutions that gauge risk by the annual volatility of market value when the real risk for endowment managers is poor long-term investment returns.

The figure below compares the performance of a hypothetical 1950 investment of $1 million in the S&P 500, 20-year Treasury bonds, and a 60/40 mix. The respective annual returns are 11.7% for the S&P portfolio, 5.4% for 20-year Treasury bonds, and 9.5% for the 60/40 portfolio.

Compounded over 74 years, these differences in annual returns have enormous consequences. The bond portfolio finishes fiscal 2023 with $48 million, the 60/40 portfolio with $853 million, and S&P portfolio with $3,626 million:

The figure also shows that the all-stock portfolio was the most volatile, with a substantial downturns after the dot-com bubble popped in 2000–2001 and during the 2007–2009 financial crisis. Such turbulence is the motivation for herd-like endowment managers to sacrifice returns in order to reduce annual volatility. On the other hand, the all-stocks portfolio generated such high returns that there surely must be ways to use that extra wealth to cushion temporary setbacks.

Three rules for stabilizing withdrawals

I recently considered three simple ways of stabilizing annual withdrawals without hobbling endowment portfolios with bonds and other low-return investments. The two base strategies are a 100%-stocks portfolio and a 60/40 mix, each with an annual withdrawal equal to 5% of the market value of the endowment. I also analyzed three rules for stabilizing withdrawals from a 100%-stocks portfolio:

  • Set withdrawals equal to 5% of the average value of the endowment over the preceding 10 years, instead of the most recent value;
  • Set withdrawals equal to the annual dividends from the portfolio, ignoring fluctuations in the endowment’s market value;
  • Set withdrawals equal to the average annual dividends over the preceding five years, ignoring fluctuations in the endowment’s market value.

My first set of comparisons assumed that each strategy began with an initial $1 million in 1950 and tracked their hypothetical performance through 2023. For example, the figure below compares the annual withdrawals for the two base strategies and for the average-dividend withdrawal rule. The withdrawals with the average-dividends strategy are consistently higher—often much higher—than for a 60/40 strategy but, before 2010, they ften lower than for the S&P portfolio. Endowment managers who value the stability of withdrawals should appreciate the fact that, with the average-dividend strategy, withdrawals never decline.

The second figure below tracks the endowment values for these three strategies from 1950 through 2023. Because of the generally smaller withdrawals before 2010, the average-dividends endowment grows much larger than either the S&P or 60/40 endowment. The results are similar for the average-endowment and annual-dividends withdrawal rules though they do experience occasional, relatively small withdrawal declines.

I also compared these various strategies for each of the 45 possible starting years (1950–1974) that had at least 30 years of investment returns. The results were remarkably consistent. The 60/40 strategy has little or nothing to recommend it beyond the fact that it is what everyone else is doing:

For the all-stocks portfolios, the 10-year, all-dividends, and average-dividends withdrawal rules tended to have somewhat lower initial withdrawals than with the 5% withdrawal rule but larger long-run endowment values. They also had much less extreme one-year declines in withdrawals. Indeed, the average-dividend rule never showed a withdrawal decline.

The role that legal requirements play

Why do so many endowment managers forego so many millions of dollars (indeed, billions for the largest endowments)? Too many investors are hostage to a groupthink mentality that values conformity above independent thought. Ironically, institutional groupthink is encouraged by a legal need to be “prudent.” There used to be a saying on Wall Street back when IBM was the belle of the ball that, just as no purchasing manager has ever been fired for buying IBM equipment, no portfolio manager has ever been thought imprudent for buying IBM stock. How can someone who fails be faulted when everyone else is failing?

Investors are, of course, hardly the only ones who seek safety in numbers.


Gary N. Smith

Senior Fellow, Walter Bradley Center for Natural and Artificial Intelligence
Gary N. Smith is the Fletcher Jones Professor of Economics at Pomona College. His research on financial markets statistical reasoning, and artificial intelligence, often involves stock market anomalies, statistical fallacies, and the misuse of data have been widely cited. He is the author of dozens of research articles and 16 books, most recently, The Power of Modern Value Investing: Beyond Indexing, Algos, and Alpha, co-authored with Margaret Smith (Palgrave Macmillan, 2023).

How can someone who fails be faulted when everyone else is failing?