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Lessons From Yale
Lessons From Yale

Can you lose a fortune during a roaring bull market?  Here’s how:

 

In 1940, the Finance Committee of Yale University adopted an investment plan to manage its endowment funds.  The plan, which was based on “considerable research and study,” appeared simple and conservative.  (An academic institution of Yale’s caliber would not dare speculate on its endowment!) Yet the result was a financial disaster whose repercussions are still felt today.  Without the use of modern derivatives (which are currently being blamed for all misfortunes under the sun) the Yale fund managed to lose $500 million!

 

Yale’s strategy, in essence, was to keep 70% of the portfolio in fixed-income securities (no junk bonds allowed) and 30% in equities.  If the equities appreciated such that their portfolio percentage rose to 40%, then some stocks would be sold and the proceeds invested in bonds to lower the equity position to 35% (raising the bond portion to 65%).  If bonds appreciated such that their portfolio percentage rose to 85%, then some bonds would be sold and the proceeds invested in stocks to lower the bonds portion to 80% (raising the stock portion to 20%).  Thus the portfolio would be periodically adjusted to partially restore the originally desired portfolio allocation.

 

It appears that the Yale Plan was more concerned with avoiding losses in stocks than in bonds.  This is understandable given the crash of 1929 and the bear market of the 1930’s.  I wonder how many investors today are unwittingly following essentially such a strategy.

 

What seemed like a perfectly sound design failed miserable after World War II.  The stock market took off in that period, while interest rates rose (reflecting the increased demand for capital after the war).  The Yale Plan dictated that in these conditions stocks should be sold in favor of bonds.  Thus, the fund not only missed a great bull market opportunity but actually lost a fortune in the declining bond market.

 

Does the failure of the Yale Plan represent a rare aberration (a bull market coupled with rising interest rates) or was the strategy faulty in principle?

 

First, the occurrence of rising stocks in a period of rising interest rates is not a rare phenomenon.  Second, the Yale Plan was formulated before the advance of Modern Portfolio Theory (MPT) which is based on mathematical optimization techniques.  Thus it was a naïve attempt to solve a complex problem.  Many volumes have since been written on the subject of portfolio management, yet private investors rarely follow these principles.

 

At first, it might seem plausible to shift from stocks to bonds as interest rates rise, but this is often wrong!  Investors have different objectives for their investment portfolios, but in most cases the correct strategy is the opposite.  I.e., other things being equal, at higher interest rates more funds should be allocated to stocks than bonds.

 

This may sound odd until you realize that the portfolio allocation should reflect (among other factors) the expected return on the assets, and usually in a period of higher interest rates the expected return on stocks is higher.

 

MPT also takes into account some or all of the following factors: the riskiness of the portfolio assets, the correlation (the degree of co-movement) of the assets, the return on the risk-free asset, the investment horizon and the desired minimum rate of return (if any).

 

In addition to the mistakes pointed out by MPT, the Yale Plan was guilty of another deficiency: it was inflexible.  Most investment systems preach perseverance and long-term planning.  But this does not mean blind adherence to a strategy that keeps failing.  This is especially true of systems that are developed from the study of a particular period (like the Yale Plan) and thus are based on simulation rather than careful reasoning.  A simulation that works perfectly in one period may not work so well in the next period when real money is put at stake.

 

Reference: “The Yale Plan”, Yale Alumni Magazine (April 12, 1940). pp, 4-5. New Haven Connecticut© Yale Alumni Publications, Inc., reprinted in Classics II, Edited by Charles D. Ellis, Business One Irwin, 1991.

 



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