Let’s get to the meat of any investment strategy: How well does it actually work?

In a prior post we talked about the Permanent Portfolio allocation which is:

25% – Stocks (in a broad based stock index fund like the S&P 500)
25% – Long Term Treasury Bonds
25% – Gold Bullion
25% – Cash (in a Treasury Money Market Fund)

This allocation will provide protection when the economy shifts through the cycles of prosperity, inflation, deflation and recession.

Now, some may be thinking that this allocation sounds very different than what they’ve seen elsewhere. For instance, the idea of owning gold is scoffed at by some investment advisors because it has no dividends or interest. Long Term Bonds? Many will tell you that they’re too risky due to rising interest rates. How about Cash? Isn’t holding a bunch of cash missing out on the hot stock market action? And, only 25% in stocks? Well everyone knows that stocks always beat every other investment so surely you want more than 25%, right? Right!?

Not exactly.

The reality is the investment markets are uncertain and unpredictable. What may look good in a theoretical backtest may blow up horribly as economic conditions change. Even worse, portfolio strategies that should work well based history often don’t work in actual application as people abandon them due to volatility and long periods of underperformance. Finally, every reputable study on the subject has shown that relying on your gut instinct, hunches, investment gurus and hot tips to run a portfolio is a road to disaster for performance and safety.

The Permanent Portfolio strategy works because it has very wide and true diversification. You have exposure to assets that can grow your money safely at all times without having to predict the future. You also have protection in the diversification against losing large amounts of money which can cause you to abandon the strategy in bad markets.

A Couple Small Changes

I did make two small changes to the original Permanent Portfolio as investment vehicles have changed in type and availability over the years. Harry Browne recommended using the Treasury Money Market Fund for cash. I personally like using Short Term Treasuries in combination with a Treasury Money Market Fund which provides nearly identical risks but slightly better returns on your cash. Also, instead of using the S&P 500 Index, I’ve chosen to use the Total Stock Market Index(also called the Russell 3000, or Wilshire 5000 index). The Total Stock Market Index provides wider stock diversification (holds 3-7000 stocks) with slightly better results than the S&P 500 (which holds 500 stocks). The slightly better result is because the Total Stock Market also holds small and medium sized company stocks which can sometimes outperform the large company stocks of the S&P 500 alone. The Total Stock Market also has expected higher tax efficiency due to how the index is constructed and managed.

You can use my changes or not. It doesn’t matter much. If you stick to the S&P 500 and Treasury Money Market Fund as originally recommended the results are within about 0.50% (one half percent) annually (favoring short-term bonds and total stock market) through the years.

Historical Returns

Let’s look at the score card and see how the Permanent Portfolio Allocation has done the past 36 years from 1972-2008 (1972 is the furthest we have data for Gold which was taken off the fixed exchange rate in 1971).

The assumption in this table is we rebalance each year to get back to our 25% allocation split among all four asset classes. In the table below I’ve highlighted in Red the asset that did the worst in a particular year and Green for the asset that did the best. Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year. In the average column I highlighted in Orange any year with a loss for the portfolio.

Data pulled from the Simba Spreadsheet on the Diehards Forum. Gold returns pulled from: http://www.finfacts.ie/Private/curency/goldmarketprice.htm. NOTE: Gold prices were largely fixed before 1971 and tied to the dollar. So the prices of gold did not move according to market fluctuations much before 1971. 2008 values pulled directly from market indicators. LT Treasuries for 2008 reflects owning 25-30 year treasuries directly and not the market index 20 year benchmark (which the portfolio is not designed to use).

Results

The Compound Annual Growth Rate (CAGR) is 9.7% for the entire period.

The worse loss for the portfolio in any one year was 1981 which had you down only about 4%. The market problems through the decades were barely registered in the final return each year. This means the portfolio was able to provide these solid and stable returns with very low volatility and risk.

You’re probably wondering how this portfolio compares to other strategies. The Permanent Portfolio was able to rack up the following returns against these competitors if you invested $10,000 back in 1972:

Now, some might be thinking: “Hey, gold was price controlled before 1971 so it’s not fair using 1972 as the start because the price of gold shot up. It made it look better than it really was!” (OK, maybe you weren’t thinking that, but I was because it’s true and we need to consider its impact). We’ll start a couple years out in 1974 then, enough time that the gold market would have settled out:

The Permanent Portfolio allocation is always competitive with the 100% stock allocation and the 50/50 bond allocation. Anything within +-0.50% of each other is essentially market noise that can easily flip back and forth each year.

The most important part is the Permanent Portfolio never had wild gut wrenching swings in value. In 1973-1974 stocks lost 50% in value. In 1987, stocks dropped 25% in one day. During the 2000-2002 Internet bubble crash, stocks dove about 40% over two years and the NASDAQ dove 80%! In 2008 stocks were down about 40% for the year.

Yet given all the above the Permanent Portfolio was able to produce positive returns during these very bad markets. Most recently in 2008 we had the worst single year market crash since 1931 and the portfolio still squeezed out a 2% profit for the year. The Permanent Portfolio allowed you to avoid all those disasters but gave you performance on par with the far riskier 100% stock allocation.

Even better, the Permanent Portfolio was able to provide real after-inflation returns during some times when the stocks and bonds couldn’t (such as the decade of the 1970′s). This means that even though inflation may have been killing your stocks and bond returns (by giving you negative real growth even though they went up in value), the Permanent Portfolio was able to go above and beyond by several percentage points to give real results that weren’t being eroded by a falling dollar.

Take a look at the returns table above and notice how you’ll always have one asset class doing very well and one doing flat or badly. Isn’t that counter-intuitive that you should be able to profit from that type of movement? Nope. It’s diversification in action. The way the Permanent Portfolio uses its assets to diversify according to economic conditions is what makes it work so well.

We’ll talk more about this in the future.

Harry Browne and Terry Coxon formally introduced the Permanent Portfolio in their 1981 book entitled: Inflation Proofing Your Investments. Like most great ideas, the Permanent Portfolio was simple, but was not simplistic.

The Permanent Portfolio investment strategy is the first one I’ve seen that developed an allocation based on economic cycle analysis. The Permanent Portfolio idea separated these economic cycles into four basic categories:

1. Prosperity
2. Inflation
3. Deflation
4. Recession

At any one time the economy will be in one of these phases or transitioning from one phase to another. This is the secret of the strategy and why it works. The strategy does not attempt to predict when these things happen or guess how long they may last. Instead, it holds specifically chosen asset classes that respond well to these cycles no matter when they happen or for how long. 

By 1987, Harry Browne took the more complicated asset allocation presented in his and Coxon’s first book above and refined it to make it easier to implement. This version of the allocation was presented in his book Why The Best Laid Investment Plans Usually Go Wrong (Find a used copy if you can. Like all of Browne’s books, it’s a must read.). The allocation remained the same in all his investing books that followed. Here it is (Preferred investment vehicle in parentheses):

• 25% – Stocks (S&P 500 Stock Index Fund)
• 25% – Long Term Bonds (US Treasury 30 Year Bonds)
• 25% – Gold (Physical Gold Bullion)
• 25% – Cash (Treasury Money Market Fund)

These assets are always present in the portfolio in a balanced way no matter what is going on in the economy. Why were these assets chosen? Because they respond to the four economic cycles listed above:

• Stocks – During prosperity, stock Index funds capture the full market returns available.
• Long Term Bonds – During times of deflation, US Treasury long term bond prices will go up quickly in value. Bonds also do reasonably well during prosperity. 
• Gold – During bad inflation, gold bullion is the only asset that provides strong protection against a falling currency. 
• Cash – During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund acts as a buffer for losses while the markets adjust during these relatively short times of underperformance. It also does well during deflation. 

Remarkably, these four asset classes are all you need to handle good and bad markets. Again, it’s simple but not simplistic. 

Even better, this allocation provides safe growth of your money. This means you won’t have to worry about the crazy swings in the stock market that may cause large losses of your life savings.

In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike. 

What this means is the Permanent Portfolio strategy will move along through the years providing stable and secure growth. 

How stable and secure? We’ll talk about that in my next post. But I feel if you combine the Permanent Portfolio with the 16 Golden Rules of Financial Safety you will have a very solid investing foundation that will get you to your ultimate destination in one piece. 

In the meantime, if you haven’t purchased a copy of Fail-Safe Investing you should really consider doing so. This book explains the method to the strategy in a very easy to read and understand form. My postings here will clarify some common questions, provide you with insight into ways to implement the ideas, and delve deeper into the economic mechanisms that make the portfolio work. 

Harry Browne also discussed the Permanent Portfolio Allocation in this radio show link.

Fail-Safe Investing