When endowment funds fall victim to poor management, the results are as bad as they are far reaching. Whether an endowment serves to prop up operating budgets or grow company retirement investments, falling market values trigger a host of undesirable outcomes. In the face of dwindling endowment assets, non-profit organizations are left with little alternative but to cut grants and programs. However, the most egregious failures are those involving retirement funds bankrupted by poor management.

Investment committees must keep in mind the dramatic effects of even the smallest investment decisions. Each investment decision has the potential to land investments hundreds of miles off course, given enough time.

John Griswold of the Commonfund Institute groups management mistakes into six main categories. Avoiding these common pitfalls can help any investment committee fulfill their fiduciary duty, and hopefully bring added investment returns over the long-run.

Tactical Mistakes

Perhaps the most common mistake is the temptation to follow last month’s or last year’s winners. Chasing winners usually means buying overpriced securities just in time for a correction. You have already missed the ride up but are perfectly poised for the ride down. Last year’s winners say nothing about the likelihood of future gains.

When it comes to picking investments, avoid the “everyone else is doing it” syndrome. Let reason drive your decisions instead of your peers’ investment philosophy or the media’s daily buy recommendations. In addition, no investment should be considered inherently too risky. Instead, the suitability of buying or selling an investment should be measured by its overall fit – or lack thereof – with the portfolio.

Asset Allocation Mistakes

A 2004 study conducted by The Vanguard Group found the most successful investment committees all held a clear understanding of their portfolio’s objectives and investment strategy. Failing to create a rigorous investment policy statement will almost certainly leave your investment efforts lacking.

Included in the IPS should be a clear statement of the endowment’s time horizon. Funds established to exist in perpetuity can and should be exposed to increased levels of risk. Doing otherwise will needlessly limit investment returns over the long-term.

David Swenson, CIO of Yale’s $15 billion endowment, warns managers against the temptation to invest heavily in fixed income securities. Keeping an equity bias will increase long-term returns. However, an equity bias isn’t enough, according to Swenson. Managers must also diversify equity funds among sub-asset classes or risk losing their investments to a big bang following a big boom.

Rebalancing Mistakes

Sticking to a disciplined rebalancing policy is essential to maintaining steady, long-term investment returns. Managers and investment committees should avoid trying to time the markets before rebalancing. Instead, rebalancing should be based on a percentage of a class’ deviation from a target asset allocation, not on market timing or on a pre-determined timetable.

Failing to utilize endowment withdrawals and contributions as part of the rebalancing process is another common rebalancing mistake. Managers who fail to take advantage of account income and expenditures needlessly increase tax liability and trading costs.

Manager Selection Mistakes

Investment committees should avoid picking managers based on their recent successes. Short-term gains (and losses) are often nothing more than the luck of the draw. Instead, choose managers with steady, long-term investment returns who have proven their returns are the result of skill, not beginner’s luck.

Spending Mistakes

Failing to create all-weather spending policy will quickly leave an endowment depleted and anemic. A sound spending formula must be able to provide stability to the organization while limiting spending in up markets and sustaining endowment purchasing power in down markets.

Governance Mistakes

Poor investment returns are often due to a lack of accountability. Committees must set appropriate benchmarks to measure manager and investment performance. Without a benchmark, there is no means for evaluation and correction.

Beware of the inefficiencies created by committees with long member rosters. Big committees result in slow decision making. Further, beware of committee members offering advice from their personal investment experience. No decision should be based on any one member’s personal investment experience.

Finally, avoid conflicts of interest.

Prudent investment practice is as much about knowing what not to do as it is about knowing what to do. By implementing a sound investment policy and avoiding common pitfalls, investment committees should be ready to achieve today’s goals and tomorrow’s dreams.

The original version of this article was published June 5, 2006. Photo used here under Flickr Creative Commons.