No portfolio is an island. In other words, a portfolio is typically only one of many "assets" that can be used to fund some type of financial goal.
For example, for a household, while the 401(k) is important, it is typically used in combination with other assets and income sources to fund retirement consumption, such as Social Security retirement benefits, home equity, etc.
The risk of these non-portfolio (i.e., nonfinancial) assets should impact how a portfolio is invested, but in reality, they often are ignored. I've covered this topic in a variety of past research papers, this one in particular, and this concept is especially relevant for endowments today, given relatively low returns expectations and high fixed spending levels (e.g., 5% of assets).
Donation Risk
The role of an endowment varies by charity. For a few (generally very large) charities, the endowment is going to be the primary source of funding, where donations are not necessarily important. For most charities, though, donations represent the vast majority of funding and therefore effectively represent the largest "asset" of the charity.
While donations are obviously an intangible asset, they represent a funding source, similar to an endowment, and should be thought of in a similar light.
Additionally, they should be considered when determining how to invest an endowment, a concept I refer to as "donation risk" in a paper I co-authored awhile back in the Journal of Portfolio Management.
Long story short, the optimal endowment allocation differs significantly across charities given the varying risks associated with donation levels. Certain charities, such as churches, have historically had relatively "safe" (or constant) donation levels, while other charities, such as the arts, have exhibited significantly higher levels of volatility.
The lower the donation risk the higher the risk capacity of the endowment. In other words, charities with lots of safe donations have the capacity to take on more risk in the endowment, but may not choose to do. Charities with relatively risky donations, have less risk capacity, but this may be offset to some extent by their risk preference (i.e., desire to invest in riskier assets).
Expected Returns
Allocation decisions for endowments today are increasingly being determined in light of expected market returns, i.e., capital market assumptions (CMAs).
Virtually all investment managers expect returns in the near future to be well below historical long-term averages, largely due to today's low bond yield environment. For example, PGIM's Q3 2021 10-year geometric expected CMAs for aggregate bonds are 2.16% and are 5.23% for US equities.
When faced with these lower returns, especially in light of a 5% target withdrawal rate, the endowment investment committee may seek to allocate more to riskier asset classes that have higher expected returns in order for the portfolio to have a higher probability of returning more than the target withdrawal rate (5%).
