What to Do When
the Wheels Fall Off the Bus

Sometimes, no matter how careful we are, things turn out badly. In the investment world that usually means our organization has just incurred larger losses investing than we ever thought possible. This leads to the logical question, “Now what?” As it turns out, there are some very practical steps we can take.

The first step is to reassess our tolerance for risk. This might seem like a backward-looking exercise, but it is not. If, as you review a severely underperforming portfolio, you find that the losses you incurred are within the range you anticipated as a worst-case scenario, then your asset-allocation and risk-management decisions were probably correct. If, on the other hand, you are kicking yourself over the size of the losses and now admit they were greater than you could stomach, then recognize that your asset allocation and other risk-management strategies were inadequate. In that case, start over. Ask, once again: Given where you are today and given your future needs, how much downside risk can you accept? That then becomes a critical data point for all future investment decisions, and one of the few data points a good consultant will need to help you build new portfolios.

Next, again root out hidden risks, including hidden leverage. Leverage can kill you. Warren Buffet, in an interview about the credit crisis, said, “Leverage [is] the only way a smart guy can go broke.” It is too true. But leverage is everywhere in the world today — explicitly in many, many closed-end mutual funds and hedge funds, and tacitly lurking on the balance sheets of many companies. In some industries, such as banking, it is baked into the regulatory framework. It takes a real effort to find solid, unleveraged investments. Also, realize that sometimes we are the problem. Our desire for large returns can drive us to seek leveraged investments. A great many hedge funds, for example, posted stunningly large numbers in up markets by leveraging their market exposure.

With underlying assets growing at 8 percent, three-to-one leverage on low-cost loans might turn the overall return into 20 percent. Who wouldn’t want that? Unfortunately, 3-to-1 leverage can also turn a 25-percent loss into a 75-percent one, which is fatal. Seeking extraordinary returns sometimes makes us vulnerable to inappropriate risks.

The final step is to rebalance our portfolios. Those who maintain their course in tough markets will invariably rebalance to target asset allocations. What does that mean? It means that even after large losses, you may end up being a buyer of equities! What?! Yes, a buyer. Here’s why. Suppose your foundation had previously decided to allocate 40 percent to traditional equities, 40 percent to hard assets and hedge funds, and 20 percent to fixed income. After a bad stretch in the stock market, that 40-percent allocation to equities is down to 30 percent or even less. If you have reviewed your asset allocation and determined that (1) the assets chosen are appropriate for today’s environment, looking forward, and that (2) it properly balances your risk tolerance and your growth goals, then you should in fact buy to bring the allocations back to your targets. The benefit of this discipline is that it gives you a reason to buy when prices are potentially very low and certainly lower than they were.

This is an excerpt from Who's Minding the Money? An Investment Guide for Nonprofit Board Members, Second Edition by Robers P. Fry, Jr.

Table of Contents
Introduction
Purchase