Gold is having a bad year. With that in mind, I think it’s important to review a few things about investing and diversification.
Realize that portfolios that are diversified usually have an asset that is a total dog. This year it’s gold. In other years it was stocks or it was bonds. This is just how it goes.
The alternative is to have a portfolio where everything is going up at the same time. This works well until the assets all decide to go down together. That kind of thing really piles on the losses (trust me, as I know this from bad experience). Naturally, picking assets that will go up all the time is the tough part. And by tough I mean impossible.
I think the Callan Periodic Table of Investing Returns shows the difficulty of picking assets that will always be winners. See for yourself:
Even with the gold slide, overall portfolio impact is muted thus far. Yes, being negative is never a good feeling. But I have to tell you that I have been investing a long time now and I’ve never been a winner every year. There are only two kinds of investors that make profits each year:
1) The lucky.
2) The liars.
So if you’re not lucky, and you’re not a liar, what can be done? Well, each investor needs to decide what is best for their personality. If they can stomach no (paper) losses whatsoever, then a 100% cash portfolio is a good option. You’ll still lose to inflation each year, but at least the bank statements won’t show the loss and psychologically this can be important for some. But if you can take some losses from time to time, then a diversified portfolio makes a lot of sense.
Investors also fixate on the developed stock market doing well this year. However, I suspect most investors do not own just the developed stock market (which would be very risky). Other assets like domestic bonds, international bonds, emerging market stocks, TIPS, commodity funds, etc. are all having problems so far. Gold is the worst of the bunch, but it’s not alone. Many bond investors are starting to feel the pinch and indeed when you read various investing forums there are plenty of discussions about investors wanting to sell all their bonds and break their asset allocation (or chase yield with low quality bonds). This is of course a bad idea as anyone that has relied on bonds during a stock market crash will tell you. But this is very common investor behavior to look at assets in isolation. What investors should do though is look at total portfolio value and remember why each asset is there even if it happens to be doing badly right now. Waiting for an asset to fall, and then selling it to move into what is currently hot, is a tried-and-true way to underperform the market over time.
In terms of diversification, if gold fell to zero tomorrow morning it would still be less of a drawdown than many stock/bond portfolios experienced in 2008. I know people that lost 1/3rd-1/2 of their life savings in that crash because they weren’t diversified well enough just as a comparison. Now, is gold going to crash to zero tomorrow? Probably not. But it’s constructive to consider extreme risks and how a model portfolio could deal with them if they came about.
The Permanent Portfolio was designed to have weights of 25% in each major asset class (stocks, bonds, cash, and gold). This means that even a catastrophic loss in one asset is contained so overall portfolio value has protection against very large losses. In other words, even if gold fell to zero tomorrow thanks to a new cold fusion breakthrough, the portfolio would suffer a -25% loss. This is not great of course, but it’s better than what would happen to a portfolio that was taking huge concentrated risks and had the same thing happen (or even milder losses like 2008′s -40% stock decline). Of course, the above also assumes no other asset goes up in value to offset these losses which is not likely.
The point of the Permanent Portfolio for me has never been that it will never take a loss because no portfolio strategy or investor can say that. Rather, it’s to distribute the risks in a way where taking a large loss becomes less likely and still provides opportunity for growing the core capital over time. I call this distribution of risk a portfolio with firewalls.
The Fed is doing a lot of things to manipulate the money supply behind the scenes and this can make the markets very unstable. Because of this, I’m happy to be widely diversified even if short-term there is pain. I say this because I know concentrating my bets presents tremendous risks if I happen to be wrong.
I run the Permanent Portfolio because I feel it offers a good balance of risk vs. reward. In the short-term it is possible to lose money with it. But long-term the losses tend to disappear into gains and I have avoided large drawdowns that are serious threats by using it. I wish I could be a winner each year, but investing just doesn’t work that way. Besides, the year isn’t over yet and a lot of things can happen quickly in the markets. I’m staying diversified.