When it comes to predicting your investment returns, nothing influences returns more than your portfolio’s asset allocation mix. It will determine most of your investment outcome. Endowment funds are no exception to this rule. For board members and trustees, choosing an appropriate asset mix is part of fulfilling fiduciary responsibility.

Endowments have historically favored the cookie-cutter allocation of 60% in stocks, 30% in bonds and 10% in cash. However, before you begin tinkering with the asset mix for your endowment funds, three important parameters must be established.

First, determine the time horizon. How much time do you have before you must spend down the funds? Endowments often provide a unique answer to this question. In most cases, funds are designed to exist in perpetuity. With an unlimited time-horizon, there is sufficient time to recover from a downturn in the markets. Unlike your retirement account or your kids’ college savings funds, an endowment fund with a limitless time horizon can afford to take greater investment risks.

This brings us to the second task of gauging your risk tolerance. You are probably familiar with the roller coaster of ups and down of the markets. Another word for these ups and downs is “volatility.” Each investment or investment portfolio carries with it a certain level of risk, a volatility. In the investing world, often times bigger risks are rewarded with higher potential returns. The question is how much whiplash can you endure in order capture a big return?

Returns are the last piece of the puzzle. Fiduciaries should focus on generating smooth, long-term investment returns. Your time horizon and risk tolerance will determine your expected rate of return. Once you have determined your expected return, you should actively seek to earn the highest possible return for the amount of risk you were willing to assume. In fact, it is part of your fiduciary duty.

Using the parameters of time horizon, risk tolerance, and potential returns, you are now ready to set your asset allocation. David Swenson, the illustrious endowment manager of Yale’s $15 billion endowment, offers two rules for investing endowment funds: 1) keep an equity bias and 2) diversify.

When tailoring the portfolio, keeping an equity bias is an essential part of boosting returns. Historically over the long-term, stocks outperform bonds, and bonds outperform cash. According to Ibbotson’s market data from 1925-2002, one dollar invested in 1925 would have grown to $1,775 if invested in US stock, $60 if invested in the bond market, and $18 if invested in cash. But, in case you are tempted to put all your money in stock, the tech bubble or that day in 1929 should serve as ample warning.

Diversification is essential for portfolios hoping to avoid the boom and bust of the markets. Diversifying your portfolio is nothing other than an investment strategy which employs your mom’s advice about not putting all your eggs in one basket. By spreading your money across different asset classes, you can reduce volatility and increase returns. The key here is to invest in asset classes which don’t move in sync with each other.

We invest in six asset classes: U.S. stocks, U.S. bonds, foreign stocks, foreign bonds, resource stocks, and cash. Spreading out investments over asset classes whose ups and downs do not move in sync both lowers the average volatility of the portfolio while increasing overall returns.

For instance, when picking U.S. stocks, we recommend diversifying even among sub-asset classes. Our philosophy is to overweight those investments where the average return is higher and the average risk is lower. We consider such decisions a win-win situation. For example, we overweight value because they have a lower volatility and provide better returns.

Endowment funds often lean too heavily on fixed income securities. We recommend investing just enough in bonds to provide the cash needed for withdrawals for 5-7 years. This allows cash to be kept at a minimum. It also allows the remainder of the portfolio to be put in equity investments knowing that their time horizon is long enough to invest for appreciation.

Endowment portfolios should also include investments in developed and emerging market securities. Although foreign markets are more volatile than U.S. markets, they don’t move in sync with U.S. markets. Allocating your U.S. to foreign stock investment ratio of 80%/20% decreases your portfolio’s total volatility. At a 60%/40% U.S./foreign allocation, a portfolio will be just as volatile as 100% U.S. stocks but have a higher average rate of return.

Resource Stocks such as REITS, oil, gold, and other precious metals provide additional diversification to a portfolio. When stocks are down, counter-cyclicals like hard assets can help buoy returns in sinking markets.

Increasing in popularity among endowment managers are so-called alternative investments. This asset class includes private equity, venture capital, hedge funds, and other illiquid investments such as timberland and real estate. This asset class brings further diversification but at a price. Alternative investments are illiquid and resource-intensive. Their value is often impossible to asses, even on a yearly basis. You may not know if you hold a winner or looser until the date of sale 20 years from now. No investment committee should pursue this class of investments unless it has qualified managers with a proven track record. Because of their expense and risk, alternative investments are suitable for large endowments only.

Although alternative investments may not be appropriate, you cannot fulfill your fiduciary duty by simply playing it safe with low-risk (and low return) securities. Failing to assume the requisite risks may actually be a breech of fiduciary duty. No individual asset class or security should be considered particularly in or out of favor. Instead, the suitability of each investment must be based on its overall fit with the portfolio.

Once your target asset allocation is set, be sure to set parameters to guide your rebalancing strategy. A good rule of thumb is to rebalance when investments drift 5% above or below the target allocation.

Asset allocation decisions will determine the growth of an organization’s investment portfolio, but good returns alone do not guarantee that you are fulfilling your fiduciary duty. Fiduciary responsibility requires that you have an investment policy and follow your written guidelines regarding risk and return.

The original version of this article was published May 29, 2006. Photo used here under Flickr Creative Commons.