Smoothing rule and ability to take risk

[traderrr]

Smoothing rule for an endowment indeed decrease volatility of distributions. But does it increase ability of an endowment to take risk?
If previous year was a bad one and market value of assets decreased:
1. Under simple spending rule the amount of distribution will be less thus decreasing volatility of endowment funds –> greater ability to take risk?
2. Under smoothing rule if endowment experienced a bad year smoothed distribution will further dampen the value of funds –> lower ability to take risk?
What is the logical link between smoothing rule and ability to take risk? Or just take it as CFAI wants it: smoothing rule increases ability to take risk?

 

[mwvt9]

If you look at it from a longer term perspective, the smoother the spending rate (less volatile) the more risk you can take because it will be easier to predict your liquidity requirements year to year.

 

[Sponge_Bob_CFA]

Agree with mwvt9. You are filling in some of the valleys by shaving off some of the peaks…thus you can take more risk as the valleys won’t be as deep as they would be without smoothing.

 

[traderrr]

Sponge_Bob_CFA Wrote:
——————————————————-
> Agree with mwvt9. You are filling in some of the
> valleys by shaving off some of the peaks…thus
> you can take more risk as the valleys won’t be as
> deep as they would be without smoothing.
Bob, you’re filling the valleyes from shaving the valleys even deaper: if you had a previous bad year and you have a smoothing rule then you are paying out even more than without a smoothing rule.
mwt’s predictable liquidity makes sense more or less to result in a higher ability to take risk. But anyway, smoothing rule further DECREASES value of fund after an extraordinary bad year and INCREASES it after a good one, thus increasing the volatility of fund’s value.
Agree, not?

 

[tibwa]

mwvt9 Wrote:
——————————————————-
> If you look at it from a longer term perspective,
> the smoother the spending rate (less volatile) the
> more risk you can take because it will be easier
> to predict your liquidity requirements year to
> year.
Good answer!
This thing seem getting easier for you by day. And that is what we all looking for.

 

[johnnash]

I agree with mwvt9 above when he talks of liquidity requirements. The CFAI text says that some endowments keep as much as 10% in less remunerative cash equivalents in order to not fall below the 5% spending rule. This is because the market value of portflio is not known until very late in the year. A smoothing rule reduces the need for such high cash balances and therefore improves risk appetite via reduced liquidity needs.