BUS 550 Module 5 Risk and Return Example

Paying 4.5% a Year Forever: Risk, Return and Diversification for a Community Foundation's Endowment

Student Name

MBA Program, Aspen University

BUS 550: Business Finance

Instructor Name

Month Day, Year

Paying 4.5% a Year Forever: Risk, Return and Diversification for a Community Foundation's Endowment

The Inland Northwest Community Foundation, a composite charity in Spokane, Washington, holds a $12 million endowment built from local bequests. Each year it grants 4.5% of the endowment's average value to local nonprofits, about $540,000 at current size. For years the endowment sat mostly in certificates of deposit and short-term bonds, which kept its value steady in dollars but let inflation erode what its grants could buy. A new investment committee has asked how the endowment should be invested to support grants indefinitely. This paper applies the principles of risk and return to answer.

The Foundation's Goal

A permanent endowment must earn enough to pay its spending rate, keep pace with inflation and cover investment costs. With spending of 4.5%, expected inflation of about 2.5% and costs of about 0.2%, the endowment needs an average return of about 7.2% a year. At the same time, a large loss in a single year would force grant cuts that local nonprofits depend on, so the committee also cares about the chance of a bad year.

Defining Risk and Return

Expected return is the average return an investment is expected to earn over time. Risk, in the sense used in finance, is the variability of returns around that average, usually measured by standard deviation (Brigham & Ehrhardt, 2020). An investment with a 9% expected return and a 16% standard deviation will, in roughly two years out of three, return between minus 7% and 25%.

Comparing Portfolios

The committee's investment consultant provided long-run assumptions: diversified stocks with an expected return of 9% and a standard deviation of 16%, and high-quality bonds with an expected return of 4.5% and a standard deviation of 6%, with a correlation between them of 0.1. The table shows expected return and standard deviation for six mixes.

Only portfolios with at least 60% in stocks reach the 7.2% target. The all-bond portfolio, though it looks safe, falls about 2.7 points a year short of the target, guaranteeing that the endowment's real value would shrink.

Why Diversification Works

The table shows something important: moving from all bonds to 30% stocks raises expected return by 1.35 points but standard deviation by less than one point. Markowitz (1952) explained why. How much a mix of holdings swings depends as much on whether its pieces rise and fall in step as on how volatile each piece is alone. When assets are not perfectly correlated, their ups and downs partly offset, so a portfolio can have less risk than the weighted average of its parts. Markowitz showed that investors should choose among efficient portfolios, those with the highest expected return for each level of risk, rather than judging assets one at a time.

Market Risk and Beta

Sharpe (1964) extended this reasoning into the capital asset pricing model. Because investors can diversify away much of the risk specific to individual companies, the market rewards only the risk that cannot be diversified away, the tendency of an asset to move with the market as a whole, measured by beta. In the model, an asset's expected return starts at the yield on a riskless security and adds the market's extra reward scaled up or down by the asset's beta. For the foundation, the lesson is that holding many stocks across industries removes risk that earns no reward; concentrating in a few local companies, as some donors suggested, adds risk without adding expected return.

The Model's Limits

Fama and French (1992) tested whether beta explains differences in average returns across U.S. stocks and found that, over the period they studied, it explained little; company size and the ratio of book value to market value explained much more. Their findings do not overturn the value of diversification, but they caution against treating beta as the only measure of risk or the capital asset pricing model as a precise forecast. For an endowment, the practical response is broad diversification across company sizes and styles rather than reliance on a single risk measure.

Where the Assumptions Could Be Wrong

The table rests on long-run assumptions, and the committee should know how fragile they are. If stocks returned 7% rather than 9% over the next decade, the 60/40 mix would earn about 6%, short of the target, and grants would have to be trimmed or the spending rate lowered. If stocks and bonds fell together, as they did in 2022 when rising interest rates hurt both, diversification would help less than the correlation of 0.1 suggests. These possibilities argue for reviewing the assumptions every few years and for keeping the spending rule flexible rather than fixed at 4.5% regardless of conditions.

Costs and Implementation

Diversified stock and bond index funds are available at annual costs well below the 0.2% assumed, and using them would let the foundation hold thousands of companies across sizes and countries. Actively managed funds cost more and, on average, have not consistently earned enough extra return to cover their fees, so the committee should choose low-cost index funds as the core of the policy.

Recommendation

The foundation should adopt a policy of 60% diversified stocks, including U.S. and international companies of all sizes, and 40% high-quality bonds. This mix meets the 7.2% target under the stated assumptions with a standard deviation near 10%. The committee should rebalance to these weights once a year, selling what has risen and buying what has fallen, which keeps risk at the chosen level. Grants should be based on the average endowment value over the previous three years, smoothing the effect of a bad year on local nonprofits.

What a Bad Year Would Mean

In a year two standard deviations below average, about a 13% loss for the 60/40 portfolio, the endowment would fall by roughly $1.6 million. With three-year averaging, the next year's grants would fall by only about 4%, rather than 13%. The committee should understand and accept that possibility before adopting the policy.

Conclusion

An endowment meant to last forever cannot avoid risk; keeping everything in bonds guarantees a slow loss of real value. Measuring risk and return, using diversification as Markowitz described and recognizing both the insight and the limits of market-based pricing models leads to a balanced portfolio that can meet the foundation's needs while limiting the damage of a bad year.

References

Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice (16th ed.). Cengage.

Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427-465. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x

Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 77-91. https://doi.org/10.1111/j.1540-6261.1952.tb01525.x

Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425-442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x