The Harvard endowment reported last week that it dropped 27.3% during its fiscal year ending June 30, 2009, excluding donations and distributions: Harvard Endowment Drops Sharply Amid Recession. A year earlier Harvard’s portfolio was trouncing the U.S. stock market and being touted as a superior investment approach.
For example, on September 7, 2008 a Wall Street Journal article entitled “Harvard’s Investments Provide a Good Lesson” praised Harvard’s 2008 outperformance of the S&P 500 Index:
How did Harvard do this? The key is diversifcation, and not just by investing in a variety of stocks and bonds. Harvard invests in 11 non-cash asset classes, only one of which is U.S. stocks. Like Yale and other large endowments, it counts on one or more of these to shine even when others are weak, achieving better long-term results than could be attained with fewer asset classes.
In retrospect, articles like the one above were a contrarian indicator that the “endowment model” was about to get a comeuppance. Over the same twelve months that Harvard’s portfolio declined 27%, the plain-vanilla Vanguard Balanced Fund (VBINX), a 60/40 blend of U.S. stocks and bonds, lost less than 14%. In other words, during the worst market crash since the 1930’s, investors who stuck with stodgy stocks and bonds did much better than sophisticated, exotic-hugging endowments.
But the big lesson here is not about what ingredients belong in a portfolio. Some types of investments will always be outperforming others. Rather, it’s that successful investing requires paying attention as much to what’s outside the portfolio — our capacity for financial risk — as to what’s within it.
In Harvard’s case, the endowment has been paying in recent years as much as 40% of the university’s annual operating expenses. Yet, believing its endowment to be the Titanic of institutional portfolios — unsinkable — the university failed to hold aside emergency reserves to cover these expenses. As a result, what should have been merely a disappointing investing year has turned into dislocating layoffs in departments across the campus.
In the long run, Harvard’s endowment will likely be just fine. With an unlimited life expectancy, time is on its side and some of its illiquid holdings will eventually rebound. In the meantime, the university can lean on alumni for donations to cover shortfalls and replenish the endowment.
Individuals have no such luxury. They are stuck with their own donations and their particular thirty-to-fifty years of investing and whatever the markets deliver within that time frame. For them it’s even more paramount to consider their capacity for financial risk before thinking about anything as luxurious as “risk tolerance.”
At this point, it looks like endowment investing offers mostly peril for individual investors. But if Harvard’s example can serve as a cautionary tale to protect individuals from a similar fate, it will, indeed, have served as a superior model.