Rolling three-year average vs. Geometric smoothing rule

CFA Level III
#1

  1. Which spending rule provides greater stability in the annual amount of spending?

  2. Which one increase risk tolerance more?

#2

i believe the geometric smoothing introduces less volatility - hence greater stability.

Reason:With a 3 year moving average - you might need to account for highs and lows on the investment portfolio. If it goes low in any one or more of the previous 3 years - your spend in the next year would go down. if it increased - it would be higher - and the base for comparison here is if the spend were all level.

and when your spend is stable - you have a greater risk tolerance as well.

#3

Thanks, so if foundation A choose rolling 3 yrs spending rule and foundation B chooose geometric spending rule. Foundation B will have higher risk tolerence (all else equal)

Just curious, what’s the drawback of geometirc spending rule?

#4

My thinking is, because a geometrically declining spending rule emphasizes recent market values of the endowment at the expense of past market values, you will be subject to higher spending this year if your recent market value (typically based on the beginning of last year) is at a high.

Don’t see language on this in the CFAI material, however.

#5

As for volatilty and risk tolerance, the 2 are interrelated:

A rolling 3 year average and a geometrically declining rule are both examples of smoothing rules, and stand in stark contrast to a simple spending rule where you just take last year’s ending market value. As a result, if the endowment has smoothing in place, much of the portfolio volatility is mitigated…Hence, allowing for the portfolio to take on higher risk and accept more short-term volatility, and importantly, target higher returns to fund programs and maintain real value.