Tuesday, June 26, 2012

The Permanent Portfolio And Its Returns

As long time readers of this blog may be aware, I almost never give specific investing advice despite my obvious interest in economics. One of the very few exceptions I have made to that rule is my strong endorsement of the Permanent Portfolio investment strategy devised by the late libertarian economist and two time presidential candidate Harry Browne. This portfolio strategy has two key components. First is an assumption that at all times the economy is experiencing one of four conditions. Those being
  • Prosperity
  • Deflation
  • Inflation
  • Tight Money - Recession
The second assumption is that while it may be amusing to prognosticate on future events, in reality the future is unknowable. Which is to say that most people are wrong, most of the time, when predicting the future.  This is especially true when the subject is economics. With these two assumptions accepted, Harry Browne set out to create a permanent portfolio (PP) that would adopt an agnostic approach towards future events and at the same time would function in any of the four economic conditions mentioned above. By "function" I mean that it would first preserve the wealth or capital in the portfolio from any dramatic losses and secondly give a reasonable positive return over time that would keep the investor ahead of inflation.

This portfolio is designed in such a way as to be exceedingly easy to construct while remaining very "low maintenance." Indeed you can build a PP in about 15 minutes using online investing tools or in a short call with your broker. Index funds and or ETFs (exchange traded funds) can be used for most or even all of the PP which has the added advantage of keeping your expenses very low.* Once set up it requires no tinkering or adjusting other than a once or twice a year peak to make sure it has not gotten out of balance.

The PP simply consists of taking four asset classes and putting one quarter of your money in each one. The PP is then left alone unless one or more of the assets rises or falls by 10% of the aggregate value of the portfolio, i.e. becoming 35% or 15% of its total value. Only then would you rebalance the portfolio by selling the assets that have done well and buying up those that have underperformed so that once again you are at 4 x 25%. In normal circumstances rebalancing events are rare, occurring perhaps once every two or three years.

Within the PP each asset class functions independently of the other three and is designed to protect you in one of the four conditions listed above. Specifically...
  •  Stocks rise dramatically during periods of prosperity.
  • Long Term US Government Bonds rise dramatically during periods of deflation.
  • Gold rises dramatically during periods of inflation/currency debasement and also protects you against catastrophic events like war or civil unrest.
  • Cash is the only neutral asset and it provides a cushion against periods when central banks tighten the money supply creating a recession and also allows you to handle unexpected emergencies in life without having to sell other assets, possibly at a disadvantageous time.
In each economic scenario one or more of the asset classes is likely to be falling. But the one correlated to that condition will normally rise so violently that it outpaces any losses from the other asset classes. The only exception to this is during periods of a deliberately induced tight money supply created by the central bank. In that scenario there is nowhere to hide other than in cash. But history has shown that such conditions are rare and usually can only last a brief period of time.

Now if you are like me, and in my experience most other people when first reading about the PP, you are probably thinking that this is nuts. That certainly was my initial reaction. In particular the idea of keeping a quarter of ones money in gold, which has no internal rate of return was something I had a really hard time with. But the true test of an investment strategy is to back test it and see how it performed in previous years. The farther back you can go the better. It is however rare for people to be able to back test many strategies going back more than a decade.

Happily that is not the case with the Permanent Portfolio.

Thanks to a gentleman named Craig Rowland who has been something of a one man band trying to keep alive the legacy of the late Harry Browne, we have detailed returns for the PP going all the way back to the early 1970's! During this time frame of four decades we have experienced every one of the four economic conditions mentioned above. We had high inflation in the 1970's, a brief but brutal recession in the early 80's when the FED jacked interest rates to break the runaway inflation, a long period of general prosperity (with a few hiccups) running from roughly the mid 80's through the late 90's and we had the financial crisis of 2008-09 and the years following where for the first time since the Great Depression we have seen the specter of deflation.

In every one of those conditions except the two brief periods of tightened money supply the PP delivered positive returns or basically broke even. In only three years out of forty (1981,1994 and 2008) was there a negative return. In each case the losses were relatively minor and were followed by violent up years. Even in 2008, which was the worst year for the stock market since the early 1930's the PP posted a loss of less than 1%. I have seen some other figures showing a very slight gain. But it's so close either way that I would basically call it break even in a year where the broad stock market was down near 40%.

Further an examination of these returns against each asset class individually and a 50/50 split in stocks and bonds generally delivered very good long term returns with virtually no volatility. Note the chart here. While both a total stock portfolio and a 50/50 split in stocks and bonds delivered statistically near identical returns as the PP over the forty year period (1971-2011), the increased volatility was dramatic. And there were very long periods where both stocks and bonds seriously underperformed. By contrast on the chart the PP is represented by something very close to a straight line, without any of the jagged rises and dips in stocks, bonds and gold on their own.

The compound annual growth rate (CAGR) for the Permanent Portfolio over the last forty years has been an astonishing 9.7% with only three very slight down years.

Does this mean that the PP is indestructible? No. But barring a truly catastrophic event...
 ...it is hard to conceive of what could inflict especially severe losses on a permanent portfolio. And if you can come up with such an event, what sort of portfolio do you see as being safe and that will still cover you just in case the world doesn't end on your schedule?

Nor is this a blanket declaration that there are no other legitimate forms of investing. Anyone who decided to adopt a Jack Bogle type portfolio with a 50/50 split in stocks and bonds using index funds would probably be OK in the long run. As long as you can handle the more dramatic ups and downs and you have a long term investment horizon that's fine. Though I would note that such a portfolio might be especially vulnerable to inflation.

Some people of course are addicted to trying to outsmart the financial markets. In my experience which I believed is backed up by mountains of statistical evidence this is a fools game. Market timing is folly. There is no bell that rings telling you when to buy and that then rings again when it is time to sell. Such systems invariably ignore the joker in the deck, which is simply unexpected events. 9-11, Pearl Harbor, JFK's assassination, 1914, the crashes of '29, '73, '87, '08-09, the abandonment of the gold standard in 71 and so on. You can't predict the future.

Even if you are able to predict the future with some degree of accuracy (and you can't), in order to beat the market over the long term you have to keep climbing a mathematical wall, that gets steeper and taller every year. That wall is called fees, expenses and taxes.

Every trade you make you have to pay someone a fee. If you are selling a security at a profit you are creating a taxable event. If you are using an actively managed mutual fund or hedge fund you are paying fees and expenses to the fund manager. And here is the dirty little secret of Wall Street (at least one of them). Those fees don't just get paid once. The money you hand over in fees and taxes this year, is gone from your portfolio next year as well. And it is gone the year after that and the one after that. In fact it is gone every year for the rest of your investing life, where it might have been making more money for you. And then you have to remember that fees and expenses are paid every time you trade or annually to your fund/portfolio managers. So this just keeps snowballing and compounding. In other words, fees expenses and taxes are a form of negative compound interest on your long term returns.

All of which means that actively managed portfolios are at a huge mathematical disadvantage when trying to beat low cost index funds that just track the broader market and charge you next to nothing. This is especially true if you are reinvesting dividends. It has been repeatedly proven in numerous studies that adjusting for fees and expenses less than 10% of active fund managers (professional Wall Street money men) will beat their respective indices over any given ten year period. Over a twenty year period that figure drops below 1%. And all the while they are underperforming they charge their clients obscene amounts of money for their non-services. If they can't do it, what makes you think you are going to be in that 1%?

Even so the urge to speculate is pretty strong. And Harry Browne even said it was fine as long as you obeyed a couple of basic rules to which I have added two of my own.
  • Never speculate with money you can't afford to lose.
  • Never dip into your permanent portfolio or designated retirement money to cover losses from speculations that go bad.
  • Never speculate in an investment you don't understand.
  • Never speculate in any manner that can leave you exposed to losses greater than your original investment. This applies especially to investing on margin.
Harry referred to money you were prepared to gamble with as a variable portfolio as opposed to a permanent portfolio for that part of your wealth or assets you are unable or unwilling to take risks with. Within the limits listed above his attitude was to go for it and have fun if you want to try and beat the market.

This post is by no means an exhaustive discussion of the topic. For further reading or research on this subject I recommend...

*I note that Harry Browne generally advised holding at least some of the gold in the form of physical bullion or 1 oz coins. Most supporters of the PP concept agree with this advice although for convenience many people also use a bullion backed ETF.


Matushka Anna said...

It looks very smart. On the other hand, one must actually have some assets to start with!

John (Ad Orientem) said...

I definitely understand the tight money problem. But if it means scrimping and eating rice and beans a couple nights a week you have to put money away for the future. The first rule is to live within your means and avoid debt like the plague. Then set up an emergency fund with minimally six months of essential living expenses in cash. After that start saving. Four thousand dollars is enough to set up a basic PP using index funds or ETFs.

Matushka Anna said...

My dear John, We are a family of seven living on about $36,000/year before taxes. Our debt (other than a little bit left on my student loan) is zero.