By Lauren Kotkin, Exponent Philanthropy

This year is showing to be another good one in the markets, said U.S. Trust Bank of America’s Steve Campisi on the August 12 Quarterly Market Update for Philanthropy conference call, provided that, as an investor, you maintained your discipline. Read the Q2 Market Update

With an improving economy, what advice does a market observer offer? Steve put it simply: “It’s wise to be mindful, unwise to be fearful.”

Wise to be mindful. Pay attention to the markets. If you’re below your long-term target weighting in a particular asset class, or not yet investing, now is a good time to increase diversification – when assets you need are “on sale.” There are currently opportunities in asset classes such as commodities, which can help guard against inflation and other market variability.

Unwise to be fearful. Don’t be afraid of risk. Instead, understand risk and manage it effectively. Within a portfolio there will always be pockets that give you cause for concern. Making small shifts in assets will affect your ability to deploy capital (make grants!) effectively.

What this looks like. A typical portfolio may have 60% in stocks and 40% in bonds. Among Exponent Philanthropy members, the typical portfolio is more diversified, averaging a little under 50% in domestic stocks and 24% in fixed income, with the reminder spread among foreign stocks, alternatives, cash/cash equivalents, and other. See member data in the 2013 Foundation Operations & Management Report 

How much diversification benefit is there in a “60/40” portfolio, and can you get more? It turns out that this simple and familiar strategy concentrates much of the portfolio’s volatility risk in a single asset category. Fortunately, effective diversification can help to spread this risk more evenly throughout the portfolio. Ideas to consider include:

• Go global in equities. When you put about half your portfolio into large cap, that investment contributes 95% of the portfolio’s volatility risk. By reducing that exposure to about 1/3 and “going global” (with foreign developed and emerging market equities), the large cap segment’s risk contribution decreases to less than 58%.
• Must you diversify the bond portfolio? Surprisingly, diversifying the bond portfolio by adding foreign bonds and high yield did not have a significant effect on decreasing risk concentrations in the portfolio.
• Add alternative investments. “Alternative” is sometimes used as a catch-all for asset classes that are not stocks and bonds. Some people think of alternatives exclusively as hedge funds, but alternatives also include real estate and commodities. According to Steve, reducing public equity by 20% and using that capital to invest in alternatives provided substantial diversification by lowering the concentration of risk coming from the large cap segment. As a result, large cap’s contribution to risk went down further from 58% (after going global) to less than 28% after adding alternatives. This fully-diversified strategy is expected to deliver about 0.4% more return (7.15% vs. 6.75% for the 60/40 strategy) and have less volatility risk (10% vs. 10.4%.) So, we accomplished two risk management goals: getting a better expected return with lower risk, and reducing concentrations of risk within the portfolio.

Remember, there are risks in any portfolio. It’s wise to understand and evaluate these risks, and it’s equally prudent to educate yourself and consider ways to diversify assets and mitigate risk as you work to meet your spending policy and, ultimately, your mission.

Mark your calendar for the Q3 Market Update for Philanthropy: Thursday, October 30 in Washington, DC at the 2014 National Conference, or Thursday, November 6, 2014, 1:00-2:00 p.m. ET

Senior Program Director Lauren Kotkin plans a range of educational programs for the Exponent Philanthropy community, including conferences, webinars, and conference calls. She also dedicates a portion of her time to managing our resources on investments. Previously, she worked at the Council on Foundations in the Family Foundation Services department. Lauren holds an undergraduate degree from Duke University and an M.Ed. from Lesley University, with a focus on using arts in education.