‍Asset Allocation - The Foundation of a Healthy Nonprofit Investment Program

The single most important factor impacting the outcome of an organization’s investment program is asset allocation, the mix of stocks, bonds and cash. The asset allocation policy a committee selects is the most important decision to be made since it drives the risk that the pool of assets is subject to as well as the reward expected. Choosing the appropriate assets is a fundamental means of seeking a balance between potential risks (downside volatility) and potential rewards (positive returns). Beyond cash, the basic toolbox is the mix of stocks and bonds. However, within these two asset classes are a broad array of sub-categories, funds, ETFs and investment managers, each of which can influence the risk profile and ultimately returns.  

Arriving at the correct balance of stocks, bonds and cash to meet a specific institution’s needs and goals is a result of applying a lot of science combined with some art. When it comes to science, Modern Portfolio Theory (MPT) is the result of robust academic research into the risk-adjusted performance of various asset allocations. MPT matches the risk acceptable to an investor to a specific blend of assets likely to produce the desired results over time. The allocation is based on historical returns, the variance of those returns, and correlations between asset classes. The fundamental takeaway from this Nobel Prize-winning research is that a carefully constructed investment portfolio can maximize your return for a given level of risk.

While science and calculations are critical inputs in designing an asset allocation policy, so is the art of careful consideration and judgment. In particular, the ability to produce forward-looking expected returns requires experience and acumen. Additionally, matching an organization's needs and aspirations with the appropriate mix of assets is a vital part of designing the investment program. There are 3 key parts of the evaluation process to determine the optimal asset allocation policy.

3 Key Components of Determining an Optimal Asset Allocation

1. Establish Time Horizon

• What are the financial needs of the organization?
• What is the timing of those needs?
  
  

2. Determine Acceptable Risk

• Are board and committee members knowledgeable about investment risks and their implications for the organization’s financial needs?
• What would a loss of five or ten percent or more of the organization’s assets mean for the  mission?
  
  

3. Understand Expected Outcomes

• Are historical returns properly assessed including multiple time horizons, rolling time periods and worst case scenarios?
• How are current market factors accounted for in considering likely future returns of various asset classes?
• Within broad categories of stocks and bonds, how are sub-categories evaluated and how do the various mixes of these affect overall expected outcomes?
• How is the correlation between various types of assets measured?

Sample Investment Committee membership for a nonprofit

Below is a simplistic illustration of 3 sample asset allocation models that demonstrates how time horizon, volatility and performance drive the design of the right mix of assets to achieve desired outcomes.

Each organization and its needs are unique. So the process to determine the proper asset allocation should result in an outcome tailored to each organization.

How to Get Started

eCIO recommends a thorough needs and risk assessment of your organization and its oversight group. This creates the basis for an asset allocation study which results in a specific recommendation of how to allocate your organization's assets along with the likely outcomes. If you would like to know more about our asset allocation process for nonprofits, please reach out.

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