Using Asset Allocation to Protect Spending

Management of portfolios from which funds are withdrawn involves two strategic decisions at the fund level: asset allocation and the spending rule. Asset allocation and the spending rule are traditionally linked, for example, to preserve capital on average, but there should be a closer dynamic linkage between the two. This article describes a new protective strategy that links spending and asset allocation in a way that preserves spending power when the market is down while still participating significantly when the market is up. This strategy is similar to Constant Proportions Portfolio Insurance in that part of the fund is kept in safe assets to preserve the value needed for continued expenditures. Like portfolio insurance, the strategy outperforms traditional strategies when markets are persistently up or persistently down, but underperforms when whipsawed by repeated up-and-down moves (This is the cost of the downside protection). This draft: October 30, 1998 I am grateful for discussions with Dick Anderson of Kennedy Capital, Bill Marshall of NISA, André Perold of Harvard, and Todd Petzel of Commonfund, and I am grateful for support from Commonfund. This article was written in connection with the Commonfund Prize and is intended to communicate to practitioners the research honored by the Prize. Commonfund (previously named The Common Fund) is a nonprofit organization that is a cooperative undertaking of educational institutions to improve the productivity of endowments. The Commonfund Prize was awarded in celebration of the organization’s 25th anniversary.