Principles of Nonprofit Investment Management - Commonfund

Since the introduction of the UMIFAin 1972 broadened the “prudent manrule” into a “prudent investor rule,”fiduciaries are permitted to take intoaccount many of the new developmentsthat have changed the landscapeof the investment world during thepast half century. The so-called“prudent investor rule” permits themto consider the expected total return(i.e., capital appreciation as well asincome) of the institution’s investments.They could then calculatethe payout rate as a percentage of theinvestment fund’s total net asset value.Most nonprofits now use this approach.But in the post-World War II decades,the concept of prudence changed fromone of avoiding risky investmentsaltogether to one of balancing therisks of various kinds of investmentsagainst one another.This change in attitude was encouragedby the theoretical work, often referredto as “modern portfolio theory,” thatwon Nobel Prizes for the economistswho originated it. Their aim was abetter understanding of the relationshipbetween investment risk and return.A highly simplified summary of theseideas might go as follows:The degree of risk entailed in aninvestment can be expressed as itsvolatility, which can be calibratedstatistically. This measurement, calledthe “standard deviation,” indicates inpercentage terms the degree to whichan investment’s value has varied – upand down a fixed 66⅔ percent of thetime – in the course of arriving at itsmean return over a given time period.Investments with higher standarddeviations will generally producegreater gains over the long term.Therefore, if you aim to get the mostout of your investments long term, youhave to own some that have a higherdegree of risk.But you can offset their volatility byalso holding investments that performdifferently – whose performance has alow degree of correlation with the restof your holdings. The volatility of oneinvestment tends to lower the volatilityof a portfolio without impairing thecombined return potential. Combiningrisky assets can lower the overallvolatility of the portfolio.- 16 -