To me, the idea of a portfolio that only holds stocks and bonds is flawed. It has too much risk of loss and too much risk of hitting a pocket of dead air where it effectively doesn’t grow for many years. If I see something is a flawed design I want to fix or get rid of it. I don’t keep using a flawed design hoping that it doesn’t break again when experience has shown, clearly, that it will with the same bad results.

Many stock and bond portfolio strategies have risks that showed up in the past and caused large losses to investors and took years to recover. These approaches encourage people to take on too much risk in stocks and don’t have strong mechanisms to roll with unpredictable economic climates. These designs have experienced severe losses that panicked investors to bail out at the worst possible time (usually at the market bottom). Or they have failed to grow money at a meaningful after-inflation rate for long periods (The 1970s and now the 2000s for example). Sometimes it’s a combination of both. Of course there were good periods when the stock market was rolling ahead and 15% a year returns just seemed so boring after a while. But the inconsistency in the stock/bond only portfolio makes the entire plan seem like a game of chance rather than a winnable long term strategy. 

So how to fix this flawed design? Well, an effective way to diversify risks of a stock/bond portfolio is to hold hard assets (like gold) and cash as well. These simple assets can make a remarkable difference in diversification, volatility, and not impact overall results to a meaningful degree. The Permanent Portfolio follows a simple formula which is to diversify first and foremost with what I call “Major Asset Classes” as opposed to “Minor Asset Classes”:

Major Asset Classes

  1. Stocks in a broadly based Index Fund
  2. High Quality Long Term Government Bonds
  3. Cash in a Treasury Money Market Fund
  4. Gold (Hard Assets)

Minor Asset Classes

  1. Slice and dicing stocks into small, large, value, growth, foreign, etc.
  2. Dissecting bonds into government, corporate, junk, etc.

Here’s the epiphany I had when I did research into the Permanent Portfolio concept: What kind and how much of the Major Asset Classes you own is far more important for diversification than how you are splitting up the Minor Asset Classes.

Way too much advice focuses on the Minor Asset Classes and not the Major ones. In the engineering world, this is what’s called Premature Optimization. In layman’s terms I guess you’d say it’s the cart before the horse. Many investors get too concerned with optimizing for returns and don’t consider what risks they could face in their strategy and, more importantly, whether their strategy has failed in the past and how it could fail again.

Stock and bond portfolios cannot be diversified well by splitting up your stocks and bonds into tiny little sub-sectors of more stocks and bonds. There are just too many market risks that can affect stocks all at once and bonds all at once to think that just making them smaller slices is going to solve anything. This is one of the critical flaws in the whole approach of stocks and bonds only.

In my world, investors really need assets like gold and cash to help diversify further and to make these stock and bond portfolios safer. Notice I didn’t use the word “safe” as there is no investment that is totally “safe.” I used the word “safer” meaning that risks are reduced across an entire portfolio with stocks, bonds, cash and gold vs. one that is stocks and bonds only. Not only is a portfolio like this safer, but it can provide good returns compared to stocks and bonds alone. Lastly, this type of portfolio has low volatility which lessens the chance of seeing a sudden big loss . This allows investors to not panic during market turmoil and make bad decisions out of fear.

In my opinion all portfolios, even those that don’t follow the Permanent Portfolio approach, should own stocks, bonds, cash and hard assets (I prefer gold) in some meaningful proportion. Stocks and bonds alone leave you exposed to serious market risks. Cash and hard assets the same. You need balance and you should own all of the Major Asset Classes at all times to have solid diversification.

And by “own” I don’t mean a 5% stake in Gold, another 5% in Cash, 10% in Bonds and 80% in stocks. I mean you should own enough of each Major Asset Class that when it comes time for it to perform, it will. Having a 5% allocation to any Major Asset Class cannot possibly offset the risks when you overweight something else. You need perhaps 15% or so in any Major Asset Class for it to have a solid diversification effect.

For instance, if you hold 80% of your money in stocks, 10% in bonds, 5% in gold and 5% in cash you are not protected. In a bad market the bonds could double in price to bring it to 20% of your portfolio, but your stocks could fall by 50% wiping out around 1/3rd of your wealth in one swoop. Or maybe your gold would double from 5% to 10%. That wouldn’t do much either if your stocks and bonds both went down together. No, you need to own more of each to limit your risks effectively in the entire portfolio. As it is, the 25% split the Permanent Portfolio uses works pretty darn well. It’s enough that if an asset goes up you can experience the benefit, but not enough that if it crashes you are taking a loss so large that the other assets have no hope of offsetting it.

The Permanent Portfolio strategy is not a magic elixir, but at the same time I think it offers much stronger diversification than a stock and bond only portfolio can ever provide. If you run a stock and bond only portfolio you may want to consider adding some diversification with the Major Asset Classes that the Permanent Portfolio concept utilizes.

Fail-Safe Investing

Fail-Safe Investing

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