As I sat down to write this post, my plan was to perform a dazzling set of statistical feats to explore the interactions and interconnections between asset allocation, spending policy, and rebalancing discipline during severe market corrections. But leaving it at that would have missed the bigger picture of volatility (good and bad), and how thoughtful investors can navigate elevated volatility.

There are two primary causes of volatility on asset prices: 1) Uncertainty about future events and their impact on asset prices; and 2) Certainty about future events but uncertainty about the impact of these events on the final equilibrium of fair value for financial assets. The impact of either type 1 or type 2 volatility can be positive or negative. And they are often occurring at the same time, although there is a handoff from 1 to 2 when there is consensus about the event.

A straightforward example of a quick volatility cycle would be the announcement of U.S. payrolls and the impact on the volatility of U.S. Treasury securities surrounding the event. Bond trading opens at 7:30 am ET, and payrolls come out at 8:15 am. Starting at 7:30 am, investors and traders are assigning probability to different levels of the payroll numbers and the impact on bonds after the announcement to inform their positioning. This creates elevated volatility as both the probabilities and the impact are debated and considered. At 8:15 am the number is announced. Cycle over? Not so fast. The event is known but the impact of the event on the final fair value is not. The morning will continue to be volatile for some time until a consensus is reached.

Nonprofits and volatility: Take Two Steps …

Right now I think it is fair to say we are experiencing an elevated level of type 1. This is nothing new. The changing of an administration always raises this level. This guide will walk you through some steps to help better navigate this challenging but not unprecedented time.

Step 1: Asset Allocation, Spending Policy, and Rebalancing (Oh my!)

“You can observe a lot just by watching.”
—Yogi Berra

First step, remind yourself of all the work that went into your asset-allocation, spending policy, and rebalancing policy decisions. These are long-term policies not to be fiddled with lightly.

The spending pattern and ending asset value of an institution’s portfolio during a market drawdown and recovery depend primarily on asset allocation, spending policy, and rebalancing policy. Looking at the impact of changing these variables informs our policies and should be used as signposts during volatile times.

Using the base case of a 70% equity, 30% fixed income portfolio; a 5%, 20-quarter moving average spending policy; and a portfolio rebalancing limit of 5%, we ran this scenario through market cycles including the 2000, 2008, and 2020 market declines and subsequent recoveries.

• The peak-to-trough drawdown was 38.4% during the 2000–03 timeframe and recovered to the high-water mark by September 2007, distributing 4.1% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 31.7% during the 2007–09 timeframe and recovered to the high-water mark by December 2010, distributing 4.2% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 14.8% during 2020 and recovered to the high-water mark by July 2020, distributing 5% of the high-water mark value at the end of 2020.

If we expand the rebalancing limit to 10%, the results are slightly different.

• The peak-to-trough drawdown was 37.7% during the 2000–03 timeframe and recovered to the high-water mark by May 2007, distributing 4.1% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 39.4% during the 2007–09 timeframe and recovered to the high-water mark by May 2014, distributing 4.2% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 14.3% during 2020 and recovered to the high-water mark by July 2020, distributing 5% of the high-water mark value at the end of 2020.

For the final scenario we reverted to a 5% rebalancing limit but changed the spending policy to 5% over a 4-quarter average.

• The peak-to-trough drawdown was 37.4% during the 2000–03 timeframe and recovered to the high-water mark by September 2007, distributing 4.2% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 39.7% during the 2007–09 timeframe and recovered to the high-water mark by July 2014, distributing 4.4% of the high-water mark value on average over the drawdown and recovery period.
• The peak-to-trough drawdown was 14.9% during 2020 and recovered to the high-water mark by July 2020, distributing 5% of the high-water mark value at the end of 2020.

In comparing all of these scenarios, changing the moving average of the spending policy from longer to shorter periods as well as changing the rebalancing target limit have an impact on the results but to a smaller degree than you may expect. I also ran one more scenario assuming that during the 2008 drawdown the portfolio is not rebalanced. In this case the recovery to the high-water mark was delayed by seven years to September 2017 compared to the 5% rebalance threshold.

Key Takeway: Pick a policy and rebalance

Step 2: Take a look at the long-term implications of the causes of volatility

“The future ain’t what it used to be.”
—Yogi Berra

If the causes of volatility result in long-term structural changes to the economy, it is important to consider the implications for your long-term asset allocation and implementation. At some point the changes will result in a new equilibrium providing both new opportunities and new risks. This is not a time to make wholesale changes but rather evaluate opportunities within the implementation of your asset allocation.

As an example, the legislation and changing regulations around the banking industry after the financial crisis of 2008 structurally altered the lending market for businesses. I’m glossing over a lot here, but one of the primary results of the regulation increased the costs for banks of lending to businesses. This was the seed that accelerated direct lending to businesses by non-bank lenders, spawning the huge growth of the private credit industry. This change provided portfolios with the opportunity to further diversify the risk asset portion of their asset allocation to include private credit alongside public and private equity.

One of the major themes today seems to be deglobalization or at least a reduction of the role of the U.S. across the globe. What are the implications for your portfolio? We are still in Stage 1 where there is uncertainty about the actual final policies to be implemented, but we have a good idea about the direction. We can start to evaluate the implications of this directional move and identify areas to explore:

• Impact on U.S. dollar?
• Industries facing new head- or tailwinds both on the U.S. and globally?
• Impact on interest rates and the cost of borrowing for individuals and businesses?
• Impact on the cost of goods and services?
• Cost of providing the essential services of your university, community foundation, cultural institution, or nonprofit health care institution?

Key Takeaway: Prepare for the impact of systemic financial and economic shifts on your portfolio

The path to get to permanent policy decisions and the resulting implications and new equilibrium are unknown as they always are at this stage. I will not try to handicap the timing or extent of these changes; that is a short-term trader’s job. Our job as long-term investors is to be aware of the changing economic conditions and avoid jumping on any bandwagon. There will be people that make outsized gains and losses guessing the future. That is not our lane. However, we can take a long-term view of the impact of changes and reflect that in our portfolios. Stay tuned….