Vanguard’s own market models project returns in the low- to mid-single digits for the traditional core asset classes. We’re not alone in this assessment. In an annual survey of capital market assumptions, 39 investment firms in 2020 gave average expected 10- and 20-year returns that were substantially lower than in 2019 for nearly all asset classes.¹ (A notable exception was private equity. More on that later.)

If return assumptions become reality, it could have dire consequences for some investors and institutions that relied on a certain return threshold to meet obligations without depleting capital or reducing future spending.

For a nonprofit, this could mean expanding fundraising efforts, implementing cost-cutting initiatives, or reducing portfolio spending rates. These actions are likely to have a greater—and more certain—impact than any single investment decision.

Of course, some investors may not have much flexibility because of fiduciary obligations or demands on the financial portfolio; in those cases, both investment and non-investment changes may be needed.

Each asset class in Figure 1 can play a crucial role in a portfolio but has very different risk characteristics. For example, cash offers high liquidity and capital preservation, serving a vital role in helping to meet short-term obligations or objectives. As the investment horizon is extended, it quickly becomes the most risky investment when measured against shortfall risk.

With a 1.2% 10-year annualized expected return, cash would result in a 66% cumulative shortfall of a 6% return objective. Even a 100% U.S. public equity portfolio—with its significant volatility and drawdown risk—is expected to fall well short of a 6% return objective.

Private equity (PE), on a standalone basis, is both high risk and extremely illiquid. However, it has the lowest shortfall risk, given its median expected return of 9.1% over 10 years in our models. In the previously cited survey, other investment advisors gave an average expected return of 9.2% over 10 years and 10.2% over 20 years—the highest among all the asset classes.

What would happen if you added PE into the portfolio mix, increased risk allocations, or both? Would it give our hypothetical portfolio the ability to bridge the chasm of shortfall risk?

Figure 2 looks at globally diversified portfolios, some with 60% in equities and 40% in fixed income and others with 70% equities and 30% fixed income. Within the equity portion of the portfolio, some have 10%, 20%, or 30% devoted to PE. (For a 60/40 portfolio, that translates to 6%, 12%, and 18% of the overall portfolio in PE, respectively.) The bars indicate the probability of meeting or exceeding annualized returns of 6% over 10 years.

In almost all cases, increasing PE allocations as a percentage of total equity improved the overall probability of meeting or exceeding a 6% return. Interestingly, the 60/40 portfolio with 30% private equity (or 18% illiquid and 82% liquid assets) has the same 27% probability of achieving a 6% return as the 70/30 portfolio with no PE.

This illustrates the potential trade-off decisions investors may need to face. Here is a clear example where they can either increase risk allocations to maintain 100% portfolio liquidity or keep risk assets steady but take on some portfolio illiquidity to improve the chances of success.

Ultimately, these decisions may not be mutually exclusive. Depending on the investor’s comfort level with different risks and what they deem a minimum acceptable probability for achieving return objectives, they may pursue some combination of the above.

One avenue, of course, is to reassess how low a return can sustain the investor's objectives. In our examples, the probability of meeting a 6% return remains daunting, even with the addition of PE. However, if you lower the expected return to 4%, the probability significantly increases, ranging from 53% to 75% for the hypothetical portfolios in Figure 3.

Interestingly, adding PE to the 60/40 portfolio increased the expected return to the point that it matches or exceeds the return of the supposedly riskier 70/30 portfolio without PE

It is only human to worry about the more immediate and visible risks such as volatility and illiquidity. But most investors do not need 100% liquidity. If that were true, none of us would buy our own homes or invest in real capital. If 18% of a portfolio is locked in private equity, 82% of the remaining assets are liquid and available for spending needs, but the overall portfolio may achieve higher returns over the long run.

This is not to say that PE is the solution for all. Most individual investors and even some institutions would not meet PE eligibility requirements, eliminating it as an option. PE investments are complex and require patience. They are a long-term commitment of investment capital and can experience negative returns in the early years until underlying investments mature. Restrictions limit an investor’s ability to transfer or sell PE investments.

In addition, there are other avenues to address shortfall risk, some unrelated to the investment portfolio. Cutting discretionary spending or launching a fundraising campaign may provide a better return than adding a riskier asset class to the portfolio.

But clearly, investors should not be so focused on temporary risks that they lose sight of the greater long-term risk of shortfalls. On the road toward financial goals, investors can easily ride out most potholes—they just require spare tires. But they don’t want to come upon the chasm with no way across. With the proper planning and navigation, that should not be an issue.