Is the Permanent Portfolio “Best?”
December 31, 2012
I posted this as a response to a thread over at the Boglehead’s forum where someone asked the provocative question about the Permanent Portfolio being “best.”
Well I’m pretty big on the portfolio (I co-authored a book about it), but I’m not going to say it’s “best”, I’ll simply list out the pros and cons:
- It’s a real return allocation.
- Diversification based on economic cycles and is future agnostic.
- Diversifies against non-spreadsheet risks.
- Doesn’t swing for the fences for returns.
- Will lag any single overweighted asset.
It’s a real-return allocation
Meaning it targets real returns over inflation (usually +3-6%) and has had a long track record of achieving that goal. A problem I see with stock/bond allocations is they can leave an investor with flat or even negative real returns for extended periods of time. For instance the 1970s were very bad for just about any stock/bond allocation. Most all I’ve looked at had serious problems with either 0% real or negative real returns over that decade. The 2000s were also very unfavorable to those allocations. But over rolling 10-year periods of time the Permanent Portfolio has not had protracted periods of these negative real returns.
Below are two charts from Simba’s spreadsheet illustrating this idea of the Permanent Portfolio vs. the standard 60/40 portfolio:
Permanent Portfolio Rolling Real Returns
60/40 Rolling Real Returns
The charts show:
1) During really good years the stock heavy portfolio turned in great real returns (1980-2000). Unfortunately, this is the biggest longest sustained bull market in U.S. history. It may repeat, but then again it might not.
2) The Permanent Portfolio had lower real returns during the heyday of stocks. But the returns are consistent through the entire time. The 60/40 portfolio you see had big problems with real returns in the 1970s and 2000s as discussed (negative or flat). The Permanent Portfolio fluctuated between that +3-6% real return range. So the overall returns are far more consistent.
Diversifies based on economic cycles and is future agnostic
Next, the portfolio chooses assets that are tied specifically to particular economic situations. Mostly, it works pretty well because there are just basic economic reasons why someone wants to own bonds (falling rates) and why someone wants to own stocks (a good outlook for the economy). I find this approach works much better to diversify against market risks than standard stock/bond allocations that rely on asset class correlations. I think that model of diversification is seriously broken and I don’t trust it. I discuss the basic problem with the entire idea in this post:
The Asset Class Correlation Model of Diversification Doesn’t Work
Also, the portfolio really is future agnostic. A stock heavy portfolio assumes that the stock market is going to win over an investor’s particular time horizon. However if you look at world markets (not just the U.S.) this is simply not true. Even in the U.S. the idea that stocks always win over time has been seriously challenged. I don’t think it is a very good assumption myself so I prefer to hold a more balanced portfolio and not make any assumptions about what will happen. Stocks are much riskier than given credit. IMO. They should be used in a balanced way.
Diversifies against non-spreadsheet risks
Spreadsheets miss a ton of risks that can show up over an investor’s lifetime. Things like Bernie Madoff, MF Global, real estate market panics, natural disasters, government interventions, etc. Think about investing for decades and everything that has or could happen going forward. The risks are limitless. So I think it’s a really great idea to diversify your assets even against things you believe are unthinkable. This means dividing up your money among more than one brokerage and even keeping some outside the country where you live.
Inside every paper currency there is an Argentina fighting to get out.
But you know some people think this stuff is paranoid and I get it. My views are colored very much by working in the unpredictable world of start-ups and doing a lot of world-travel (25+ countries at this point). I just got back from a trip to Argentina where inflation is perhaps 25%+ and where the currency exchangers (Travelex) won’t even buy Argentine Pesos back from you. I’m not saying that any country is going to go the route of Argentina, but I will simply say this:
Inside every paper currency there is an Argentina fighting to get out.
Showing a red-hot CAGR in a spreadsheet backtest is pretty easy. I can do it right now. But there are other non-spreadsheet risks that I think investors should consider and the Permanent Portfolio does consider them as part of the model.
Now for the cons
First of all, the portfolio is not swinging for the fences for returns. I think people doing that approach are probably going to fail long term anyway because the volatility will wipe them out emotionally. Also I think that investors should take risks on their careers, and not with their life savings. I discuss this idea here:
Take Risks in Your Career Podcast
You can’t go back and re-earn the money you take huge gambles with in your portfolio. This risk gets incredibly higher the longer you go out on the timeline of life. Taking a big loss late in your investing career can be fatal. Even taking it mid-way can be a big problem because it could force you into a far too conservative allocation that won’t grow enough. I think the Permanent Portfolio has a great balance of growth with risk protection. This translates to investors being able to stick with the plan no matter what the markets are doing.
The next con is the Permanent Portfolio will lag any particular single asset you overweight. So if stocks are doing really well, you’ll hear everyone around you bragging about their hot returns when you have comparatively little. Of course the portfolio likely is beating inflation by a decent amount so you are doing OK, but you probably aren’t going to pull down 15%. Then again, you probably aren’t going to take a -30% hit either. Investors in the strategy need to simply accept that the portfolio is pretty boring and you won’t have much to talk about at cocktail parties. But personally, I want my life savings to be pretty boring so I’m OK with that.
I can probably add more, but you get the idea. The Permanent Portfolio is “best” for some people that want:
- Low volatility.
- Wide diversification.
- Likelihood of real returns.
- Protection against extreme events in the market.
If that’s what you want, it may be a good fit. In which case the Permanent Portfolio is really only going to be “best” depending on what you want for your investing goals.
American Association of Individual Investors Article on the Permanent Portfolio
December 29, 2012
The December 2012 AAII Journal featured an article written by Mike and me on the new Permanent Portfolio book:
The Permanent Portfolio: Using Allocation to Build and Protect Wealth
Simple, safe and stable: These are the three tenets of the Permanent Portfolio, a strategy invented by the late Harry Browne to help investors grow and protect their life savings no matter what was going on in the markets.
Over the last 40 years, the strategy has returned 9.5% compound annual growth. The worst loss, a drop of 5%, occurred in 1981. In 2008’s financial crisis, the portfolio was down only around 2% for the year. We think that’s pretty impressive for a strategy that appears so startlingly simple on the face of it.
The articles is available to AAII members and gives a quick overview of the Permanent Portfolio strategy. Big thanks to the editors of the AAII Journal for allowing us to contribute this piece to their publication!
Beware of Investors Bearing Charts
December 28, 2012
Since I’ve been venting about topics like Tapas, I may as well keep the ball rolling on another topic I really can’t stand: Charts. Specifically, investing charts. Even more specifically, investing charts going back decades that ignore history and make gross assumptions about the future.
Here are the big problems with investing charts that I often see:
The Problem of Induction
This is partially the idea that what you see around you is bound to continue on into the future as it did in the past. Big mistake. A line on a chart may not always continue going up for instance even though a chartist may think it will. I feel sorry for people that just don’t seem to get this idea. Risk is real and can show up at any time. We need to consider how unknown risks may affect our investing strategy instead of looking at what a chart is suggesting. The line on the chart you see dragging out into the future may suddenly go straight down tomorrow. Investors that use charts to read into the future are going to be bitten by the problem of induction eventually.
Assuming Monetary Policy Explains Everything
I also dislike when people try to attach simple monetary policy explanations to complicated problems, or even worse, to obviously wrong applications. For instance, someone will show a chart that covers a tumultuous period like WWII along with interest rates, GDP, etc. The chartist reads into monetary policy and tries to discern the trend and reasons for the market performance. They seem to not consider that the monetary policy is probably a fallout of the historical situation and not what was causing that situation.
For instance, when I see a chart covering something like WWII do you know what I read into it as the cause? Not interest rates from the central bank that’s for sure! How about cities being bombed into the ground, low unemployment because you are shipping citizens into war, price controls affecting commodity prices for wartime production needs, etc.? Don’t show me a chart about how low unemployment and how high GDP were and tell me that war is great for the economy. How about these people use their heads and realize that when you kill millions of people and destroy major productive resources you are not helping anyone? How wars affect the economies of all the players is completely unpredictable. Period. No chart will be able to predict the outcome of the situation nor explain it after the fact. One thing I do know, interest rates are not high on the list of considerations of people having their homes shelled and kids sent off to combat.
Thinking Spreadsheets Have All The Answers
“Step away from your spreadsheet and come out with your hands up.”
A lot of portfolio backtests (and their resulting charts) are just silly. Any moron can go into a spreadsheet to find what worked best in the past (especially when cherry picking dates). But it takes some real thinking to work out a strategy that can deal with future unknown risks. You can’t optimize for returns going forward because you don’t know what those returns will be. So anyone designing a portfolio based on what did best in the past is making a huge tactical error with their investments.
What I liked a lot about Harry Browne and the Permanent Portfolio is, as entrepreneur, I really feel he understood the nature of the unknown and investing risk. It’s not about going into a spreadsheet, hand picking some dates and assets to see what did best, and then going out and buying those investments. If investing were that easy we’d all be rich. Rather, backtesting can really only show you what didn’t work well in the past so you can avoid repeating those mistakes or at least be aware of those risks. Backtesting can never prove something will work best going forward. Also backtesting will never show you extraordinary events such as civil unrest, unprecedented government intervention in the markets, etc. These risks need to have some diversification applied as well and the Permanent Portfolio actually considers these risks that spreadsheet only portfolios do not.
This is why I find it so funny when some comment that an asset like gold is “worthless” in an investing portfolio because of some contrived spreadsheet work they did. I wonder if these people have ever gotten far enough away from their spreadsheets to see how the planet really works? I’ve been to over 25 countries in my life and I can tell you that economies can move quickly from good to bad and governments do stupid things all the time. Having some portfolio insurance like gold around is a really splendid idea.
So yeah the Permanent Portfolio holds gold and diversifies with other assets likes stocks, bonds and cash. But what in history suggests this is not a good idea? It doesn’t matter what your chart is showing you worked best over a particular time period. The fact is that concentrating your bets is dangerous and sometimes stocks and bonds don’t pay out on your timetable. This is just how life works so diversifying a little bit is prudent.
Use Charts Intelligently
Investing charts are one tool investors have, but I think they need to be used within their limits. Charts can’t predict the future, but maybe they can guide you away from notably bad ideas. Likewise, they can also be useful to test out theories for big flaws you might have missed. Even then, they need to be used with some judgement about the unpredictable future and the idea that history has many ugly details buried within it that aren’t simply explained in a chart of spreadsheet data. When looking at investing charts, just keep in mind that pretty colors and compelling growth patterns may not be enough to prevent disaster if you don’t use the data intelligently.