How to Use Portfolio Modeling to Answer “What If?”

Jan. 23, 2024

When it comes to non-profit investment planning, we advocate for a goals-based approach. Boards and committees should envision what they want to achieve, set a baseline around expectations for the future, and establish guidelines and policies designed to achieve the desired outcomes.

A challenge, however, arises for a simple reason: the future is uncertain.

A set of guidelines might help to achieve your goals on average, but what if future outcomes are below average? Or what about tail risk, which is when something occurs outside the range of what you might normally expect?

Given the economy and market environment today, uncertainty seems to be exceptionally high. To navigate this environment and help board and committee members meet their fiduciary duties, we help our non-profit clients use investment modeling tools to answer a very important question: What if? Consider the following examples:

  • What if there is a large drop in our portfolio's value?
  • What if our investment policy becomes more aggressive? What if it becomes more conservative?
  • What if inflation is higher than expected?
  • What if we increase or decrease our spending rate?
  • What if donations or other sources of revenue slows?

These might be among the most important questions non-profit leaders can ask today. How would your investment portfolio and your organization’s financial health change under these scenarios? Every situation is different, but the following is a typical investment modeling process that can help organizations make important decisions in a world of high uncertainty.

1. Create a Base Case Scenario

Projecting future outcomes can help establish a base case for expectations. First, there are several assumptions that need to be made, including portfolio returns, portfolio volatility, inflation, withdrawals, and contributions. After that, a robust investment model should account for the inherent uncertainty that might be present in several of these variables. To do this, a projection can be built that simulates a range of future outcomes.

There are several statistical techniques to do this, but the output should be generally the same: a range of future outcomes to help gauge the probability of achieving certain goals and/or avoiding unwanted outcomes.

2. Answer “What If?” by Adjusting Your Assumptions

What are some difficult situations that you’d like to evaluate? And then, how do these affect your portfolio and your organization’s finances? Likewise, does changing the variables that are under your control (e.g., asset allocation, spending rate, contributions, etc.) improve or worsen your probability of success? The next step is to test the “what if?” in your model by adjusting assumptions or stress testing (i.e., forcing adverse conditions upon the model).

One common example today is to look at different allocation combinations between major asset classes like stocks, bonds, cash, and alternatives. Would different investment guidelines improve outcomes?

Another example is to fix the sequence of returns so that difficult results come at the beginning of a projection. For instance, an immediate fall in a portfolio’s value would clearly create near-term headwinds, but how much do outcomes change over the longer term?

If a situation can be imagined and parameters in the model can be set, then there is no limit to the number of different scenarios that can be evaluated this way.

3. Evaluate the Results

Non-profit fiduciaries have a responsibility to make prudent decisions. The portfolio modeling process described above provides data to consider and helps back those decisions by careful analysis instead of anecdotes or instinct.

Furthermore, when the results are calculated, we’ve always found there to be inherent tradeoffs, implying there is sometimes no single “right” answer. That’s why this last step should include a discussion between all relevant stakeholders – your board, investment committee, staff leadership, and investment advisor. Making decisions is about more than just using a formula or algorithm. It’s about using judgment to determine what risks and outcomes are acceptable, and which must be avoided. We encourage board and committee members to think about the role their investments play, their other sources of revenue, and the impact different outcomes would have on their ultimate charitable mission.

We can help

Advance your mission by partnering with a team that provides comprehensive support – from investment management to board and staff education and beyond, we’re here to help. Schedule a call with us to start leveraging our planning tools to answer the “what ifs” for your organization, so you can focus on your goals and those you serve.

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The information in this paper is not intended as legal or tax advice. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation.

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