The Permanent Portfolio allocation is 25% stocks, 25% bonds, 25% gold and 25% cash. In this series of posts we’re going to talk about how to implement each one of these components to take advantage of the economic cycles of Prosperity, Inflation, Recession and Deflation.

This FAQ is divided into two sections: Short Answers and Long Expanded Answers. If you don’t want to know the details then just read the Short section and skip the Long Expanded section. This page will be updated from time to time as more common questions and answers are needed.

In this series we talk about the 25% bond allocation and how it protects you from deflation and helps during prosperity.

Short Answers

Is there a Harry Browne Radio show that discusses some of the topics in this FAQ?

He covers some of the topics in this FAQ in these shows:

October 24, 2004 Radio Show

April 24, 2005 Radio Show

Why do I want to own bonds in my Permanent Portfolio?

Bonds help out under various economic conditions to protect the Permanent Portfolio. Under times of prosperity when the economy is stable and growing bonds provide a steady income stream in addition to the growth of stocks. When markets go through deflationary gyrations that are bad for stocks and gold in the portfolio, bonds can go up greatly in price offsetting losses in these other assets.

What kind of bonds should I own in the Permanent Portfolio?

You only want to own the highest quality long term bonds you can buy. For US investors that means you only want to purchase US Treasury Long Term bonds because they have no credit, default or call risk.

What is credit or default risk in bonds?

Credit or default risk is the possibility the bond issuer may not pay back the bond holders (aka. going bankrupt).

Credit risk can show up by a rating agency downgrading a bond issuer and this will spook investors who will demand higher interest rates to compensate. This will drive down existing bond prices. The bond issuer may still be able to pay the bond, but investors fearing the higher risk of default will want more compensation to hold onto the bonds.

Default risk is the possibility that the issuer may simply go bust and not pay anyone except for maybe pennies on the dollar during the bankruptcy liquidation (if that).

Most bonds have credit and default risk and this is priced into them as higher interest rates. However the US Treasury bonds are considered extremely low risk of defaulting because the government can always tax people or print money to pay off the debt. As a result, US Treasury bonds pay lower interest than other types of bonds because the risk of holding them is lower.

When you say “Long Term Bonds” how long do you mean?

Any bond 25-30 years to maturity is perfectly fine for the Permanent Portfolio.

Do I need to hold the bond for the entire time?

No. You will sell the bonds when they have 20 years left of maturity under the Permanent Portfolio strategy. You will then buy new 25-30 year bonds to replace them. This is a simple process that any broker can handle for you in a matter of minutes (or seconds). The bond markets buy and sell bonds of all different maturities constantly and you aren’t obligated to hold a bond until it matures.

What is deflation?

Deflation is a general contraction in the prices in the economy due to a shrinking of the money supply. As opposed to inflation, under a deflation scenario every dollar you hold becomes worth more and can therefore purchase more. Prices under deflation are falling, sometimes rapidly, and the economy will be suffering as the new lower price levels move through the market.

Why own bonds for deflation?

Bonds with a long maturity will go up sharply in value during times of deflation because market interest rates will be falling. Falling interest rates means that bonds you hold that pay a higher interest go up in value because the payments are worth more. Under deflation the general market interest rates will fall, sometimes rapidly. This is good for certain types of bonds.

For example if you own a bond paying 5% a year for 30 years and the new market rate for bonds falls to 3% a year for 30 year bonds then your 5% bond is more valuable to investors. After all, if you were a buyer which would you rather own: A bond paying 5% for 30 years or a bond paying 3% for 30 years?

If they were the same price you’d of course want the 5% bond. However the market would never let this price disparity exist. Instead what happens is your 5% bond price goes up in value until the effective payout matches the 3% bonds in the market over 30 years.

The rule you need to remember is this: Bond prices move opposite to interest rates.

If rates go up, bond prices go down. If rates go down, bond prices go up.

How else do bonds help a portfolio?

Economic uncertainties that are hurting stocks will sometimes help bonds as investors look for safe places to put their money. You could see bond prices go up therefore even if there isn’t necessarily deflationary forces in effect yet.

Bonds also provide an income stream through their interest payments. The income from the bonds can be reinvested into the portfolio to compound.

What economic conditions will hurt bonds?

The #1 enemy of long term bonds is inflation.

Inflation causes interest rates to rise as the value of the currency declines. This is because holders of the falling currency want more interest to offset their risk of the money losing value faster than they can earn a return.

Under conditions of rising interest rates (such as inflation), bond prices will fall. Under rapidly rising interest rates (such as really bad inflation) bond prices may fall very sharply. After all, if you own 5%  30 year bonds and investors can buy 10% 30 year bonds on the open market why would they want yours unless you give them a big discount?

Bad inflation can not only cause bond prices to fall 25, 30, 40, 50% or more, but the money they are paying you in interest payments is also depreciating. Inflation therefore is a double blow to bond holders.

What assets in the Permanent Portfolio protect me from bond losses if rates go up due to inflation?

Under bad inflation situations the gold allocation in the Permanent Portfolio will go up sharply in price and should offset the bond losses you’d experience. This is what happened in the 1970′s when inflation was double digits and bond holders were being badly hurt. A portfolio that held gold offset all losses in the bond allocation and actually turned a profit during that time.

There are no guarantees of course, but this is what the economic forces should ultimately reflect over time.

Can I hold Long Term Treasury Inflation Protected Bonds (aka. TIPS) instead of nominal Treasury Bonds?

No you can’t. TIPS are designed to respond to inflation. They will not provide the spike in price that nominal Long Term Treasury bonds will during deflation. You should only buy nominal Long Term Treasury Bonds, not TIPS, for the Permanent Portfolio.

Can I hold Municipal Bonds instead of nominal Treasury Bonds for the portfolio to save on taxes?

No you can’t do this either. The tax savings is not as large as some may believe because Treasury bond interest can’t be taxed by the states. Even if you do save some on taxes, municipal bonds have credit risk. Even worse they have call risk which means they won’t respond the same to market conditions as Long Term Treasury bonds will.

In the case of severe deflation, many municipal bonds paying a higher interest rate can be called back by the issuing agency away from bond holders. Therefore the bonds you think you held to offset portfolio losses due to deflation are no longer available to you. You’ll get your money back, but you’ll have to scramble around for new bonds along with everyone else right at the time you don’t want to be buying bonds (you’ll be paying a premium price in that type of market).

The tax savings of municipal over Treasury bonds is not enough to offset the capital appreciation Treasury Bonds have in bad markets. Please go down to the Long Expanded answers section and see the chart comparing these various funds to see what is meant by this.

How do I buy US Treasury Long Term Bonds?

How do I buy US Treasury Long Term Bonds at Auction?

Buying bonds at auction from the Treasury can be done in two primary ways:

1. Open an account at Treasury Direct to make the purchase.
2. Use your mutual fund company or broker to make the purchase.

Treasury Direct is a service of the US Treasury that allows individuals to participate in the auction and buying process of Treasury bonds of all types. Treasury Direct accounts can be set up like any brokerage account and your bond purchases will be held in custody for you by the service.

Brokerages can purchase bonds at auction as well. You should check their website or speak to a representative to find out the process.

What bond fund can I use to purchase Long Term Treasury Bonds?

There is only one at this time that is acceptable for use in the Permanent Portfolio:

iShares Treasury Long Term Bond ETF (Ticker: TLT)

This is the only bond fund that Harry Browne mentioned as being acceptable in his radio shows. It’s also the only one I’ve seen since that fits the primary criteria for bonds in the Permanent Portfolio:

1. It only holds 100% US Treasury Long Term bonds.
2. It only holds bonds with maturities over 20 years.

Not only this, but this bond fund is very cheap which is a requirement in any bond fund because the returns from interest tend to be low and you don’t want your profits being eaten up by high management fees.

Any brokerage or mutual fund company should be able to buy this bond ETF for you.

Why not use other bond funds?

Most bond funds have several problems for the Permanent Portfolio:

1. They don’t own 100% US Treasury Bonds – Many mix in other government agency bonds, corporate bonds or repurchase agreements which is not acceptable.
2. They don’t own long enough maturity of bonds – The Permanent Portfolio strategy needs very long term bonds to balance out other assets in the portfolio.
3. They’re market timers – Many try to time the market and shift around bond maturities to increase performance (which fails).
4. They charge too much – Bond funds usually have low yields. If you pay a manager 1% in fees and the fund yields 4% a year then you’ve given 25% of your profits away (4% – 1% management fee = 3% to you). It doesn’t sound like much, but it adds up through the years.

Should I purchase the bonds directly or use a bond fund if I have the choice?

It’s always better to own the bonds directly either through Treasury Direct or your broker. It’s one less layer of things to go wrong in the portfolio. Also, it’s cheaper because you won’t be paying management fees to own long term bonds which you only sell every 5-10 years in the portfolio.

However, if you have no other choice due to various reasons (e.g. your retirement plan doesn’t allow direct bond ownership or you feel uncomfortable doing it yourself), then you may use a fund. The iShares TLT fund is still an excellent choice in this situation and the costs are reasonable.

Can I use an actively traded bond fund for the Permanent Portfolio instead of direct bond ownership or a long term bond index fund?

No you can’t.

You don’t want a bond fund manager moving between long, short, intermediate, corporate, junk or whatever other kind of bond they think they need to beat the market. The Permanent Portfolio needs US Treasury Long Term bonds for specific reasons and you can seriously compromise the protection if you use an actively managed bond fund.

This rule is not flexible. Do not break it.

My retirement plan doesn’t offer any suitable long term bond index funds. What can I do?

This is an unfortunate problem for many workers. Index funds are not as profitable for mutual fund companies who like making big fees on actively managed funds. As a result, many 401(k) and IRA plans don’t offer index bond funds.

In this case you have few choices:

1) Move your IRA to someplace like Vanguard that has index funds and allows you to purchase bonds at auction or the secondary market easily.

2) Ask your retirement plan administrator to make bond index funds available either by requesting them from the 401(k) custodian or if necessary moving the company 401(k) plan to a new custodian that does offer them.

3) Use the funds that you have to the best of your ability.

If you are forced into option (3) (and many are), then try to look for the following in your funds that you do have:

• Lowest expense ratio possible.
• Uses US Treasury Bonds only.
• Has the longest maturity US Treasury Bonds available.
• Won’t be actively managed with someone shifting around bond maturities as they feel is appropriate. You want static maturity targets in the bond fund.

What’s the recap?

1. The Permanent Portfolio owns Long Term bonds to protect against deflation, but also help somewhat during prosperity.
2. Credit risk, default risk and call risk should be avoided with your bonds – Bonds are for safety, not speculation.
3. The best bonds to own for deflation protection are US Government Long Term Treasury Bonds.
4. Do not purchase TIPS, Municipal bonds, high-grade corporate bonds or junk bonds.
5. You should purchase bonds with a maturity of 25-30 years.
6. You will hold the bonds until they have 20 years left of maturity and then sell them to buy new 25-30  year bonds.
7. Bonds can be purchased from the Treasury directly or through any broker for a nominal fee.
8. If you need or want to use a bond fund then use the iShares Treasury Long Term (Ticker: TLT) ETF.
9. Never use an actively traded bond fund if you want to own a fund. Only passive index funds are allowed.
10. If your retirement plan doesn’t offer a suitable long term bond fund then find the one with the longest term bonds available or move your money to another fund provider if you can.

Long Expanded Answers

How can credit, default and call risk impact bond performance?

When investors get scared in a bad market they’ll shun anything with risk. If they think the stock market has too much risk of loss, the corporate bond market has too much risk of default and municipal bonds are risky due to call privileges they’ll flock to Treasuries for safety.

You saw this happen in late 2008 when the stock market crashed and, fearing widespread deflation combined with credit problems, investors sold everything and bought Treasury Bonds for protection.

The chart below shows the year 2008 and a Long Term Treasury Bond Fund (Ticker: TLT) vs. Vanguard’s Long Term Corporate Bond Fund (Ticker: VWESX) vs. Vanguard’s High Yield Corporate Bond Fund [aka. Junk Bonds] (Ticker: VWEHX) vs. Vanguard Long Term Tax Exempt Bond Fund (Ticker: VWLTX) vs Vanguard Treasury Inflation Protected Securities Fund [TIPS] (Ticker: VIPSX).

You can see that when the stock market was crashing and deflation was feared that Treasury Long Term bonds went up nearly 35% in value while Long Term Corporate bonds lost -5% (down -20% at the worst), High Yield Bonds (aka. Junk Bonds) dove a painful -30% in value, Long Term Tax Exempt bonds sank -10% and TIPS were down -7% by the end of the year.

(Click on chart for larger view. Chart courtesy of stockcharts.com)

US Treasury Long Term Bonds ETF (Ticker: TLT) in red (up about +35%)

Vanguard Investment Grade Corporate Long Term Bonds (Ticker: VWESX) in dark blue (down about -5%)

Vanguard Treasury Inflation Protected Securities (TIPS) Bonds (Ticker: VIPSX) in light blue (down about -7%)

Vanguard Long Term Tax Exempt (Ticker: VWLTX) in magenta (down about -10%)

Vanguard High Yield Corporate Bond (Ticker: VWEHX) in green (down about -30%)

In the above it’s clear to see that when credit and call risk showed up in Fall 2008, people were paying premium prices for Treasury Long Term bonds over corporate long term bonds, junk bonds and municipal bonds. TIPS, which respond only to inflation and not deflation, provided no diversification benefit under this scenario.

The end result was that owning Treasury Long Term bonds in the Permanent portfolio allowed investors to harvest those gains and offset almost all stock market losses in 2008.

What about buying high yield bonds (aka. Junk bonds) to get some extra interest and diversification?

NO! Bonds are for safety and not speculation. Buying higher risk bonds means you are “chasing yield” and this can be dangerous because higher rewards ALWAYS means higher risk.

If you need your bonds to protect you during a bad market you don’t want them to be subject to credit or default risk. Junk bonds (aka “High Yield Bonds”) have very high credit and default risk. They are one of the worst investments to own. You get all of the volatility and risk of stocks but none of the upside potential. They also are also heavily taxed if you are unable to shelter them. Lastly, you don’t get the protection of quality bonds when you need them.

During 2008 when the credit crisis hit many junk bond funds sank by 30% in value! Here’s a chart below of their performance against high quality US Treasury Long Term Bonds:

(Click on chart for larger view. Chart courtesy of stockcharts.com)

Long Term Treasury Bonds are in red. High Yield bonds are in blue.

Imagine owning High Yield bonds thinking they would protect you in a bad market only to see the fund sink by 30% along with your stocks. That’s not the kind of diversification you need in the Permanent Portfolio.

Isn’t after tax yield all that’s important for bonds?

It’s only half of the issue. There are three ways to make money on investments:

1) Dividend

2) Interest

3) Capital Appreciation

Stocks can provide growth with dividend payments and capital appreciation (through an increase in share price).

Yet bonds can provide growth through interest payments and capital appreciation (through an increase in bond price).

Many people looking at bonds focus too much on the yield (interest payments) of the bonds and not enough on how they may move under market forces. Treasury Bonds are somewhat unique in the bond market because they move so powerfully to interest rates. This response is shown in a decline in yield, but a rise in price (capital appreciation) in certain times.

In 2007 for instance Long Term Bonds started off yielding about 5%. By the end of 2008 they yielded below 3%. Rates on Long Term Bonds fell a measly 2%. That’s not a big deal right? And someone looking at these numbers in 2007 may have dismissed Long Term Treasuries as being a bad deal at 5%. Perhaps they used their money instead to purchase corporate or municipal bonds trying to get extra after-tax yield.

Yet people who bought Long Term Treasury bonds in 2007 and held onto them through 2008 saw them appreciate in value by 30-35%!

That’s what a measly 2% drop in yields can do for US Treasury Long Term bonds in the Permanent Portfolio.

Since there is no rule that says you need to hold onto Treasury bonds until they mature, what smart investors did was rebalance and sell off the excess profits in their Long Term Treasury Bonds by the end of 2008 to bring their bond allocation back down to 25% of the portfolio. They then moved the money gained to other parts of their portfolio that were lagging (such as stocks).

In other words, the fact that the yield on the bonds in 2007 seemed low was only one piece of the calculation. Many investors focus on yield and forget that high quality bonds also have capital appreciation in certain markets. Not only this, but chasing higher yield means you are always taking on higher risk. There is no free lunch in economics. In 2008 that risk showed up for many bond holders.

I’ve heard from some analysts that the US Government may default one day and I shouldn’t own their bonds. How can I avoid this risk?

This is a remote risk because the US Government can always tax people or print money to pay their debt. Neither is a good solution, but they won’t “default” in the traditional sense. Your 25% gold allocation in the Permanent Portfolio is a solid hedge against this situation if it should occur though. Also keep in mind that governments all over the world engage in the same activity constantly so there really is no place to hide from it.

Also this has been predicted for decades now. In fact, Harry Browne wrote a book in 1989 that talked about risks of debt to the US called The Economic Time Bomb. Do you know what his answer was to protect you against this possibility? That’s right, diversify into the Permanent Portfolio strategy and don’t worry about it.

When you say the US Government can print money to pay off bond debt isn’t that bad?

Yes. That’s where inflation originates is the over-printing of money. The US Government will likely never “default” on their bonds in the traditional sense. What they’d likely do is simply print so much money to make the dollar worthless. At the extreme they could start printing out $1,000,000 bills and handing them out to bond holders. At this level of inflation the money would be worthless (it probably couldn’t even buy a cup of coffee), but technically they didn’t “default” because you were paid. You were just paid in worthless paper, but you were paid.

In this case the gold in the Permanent Portfolio would be worth a fortune as people fled for the exits out of the Dollar. So even though at the extreme your bonds are worthless, you’d probably find that the gold protected you from virtually all real losses in your portfolio.

Again this is an extreme example, but if the government started printing money to bring inflation to 10%, 20%, 50% or higher each year it would be really bad for your bonds, but the gold allocation would do very well under this scenario.

What is the secondary market and how do I buy US Treasury Long Term Bonds on it?

The secondary market is simply the place where you buy existing bonds that are not from a treasury auction directly. These bonds may have various maturities from the longest 30 years available to very short maturities.

Brokerages and mutual fund providers can often purchase bonds on the secondary market very easily during any trading day. US Treasury bonds are very liquid and trades are simple and straight forward. Again, contact your brokerage or mutual fund provider for more information on purchasing Treasury Long Term Bonds.

What about owning International bonds?

International bond funds have significant currency risk because they won’t be denominated in your local currency (e.g. European bonds may be denominated in Euros but you live in the states where you use Dollars). Currency risk means that if the US dollar is strong but the international currencies are weak you could lose money on your international bonds even if they go “up” in value.

For instance let’s say you own some international bonds yielding 5% a year. During the year though the dollar has a strong rally and goes up in value 20% against other currencies. At the end of the year you will find that yes you received your 5% payment, but because the dollar went up so much in value the bond fund price may be down -15% (5% appreciation minus the 20% depreciation due to the dollar increase). Situations like this could happen during times of deflation or disinflation in the US.

Likewise, you could be in a situation where the dollar sinks and your international bonds go up greatly in value due to the exchange ratio favoring foreign currencies. This may happen during times of inflation in the US that are hurting the dollar. However since you own gold in the portfolio to protect you from inflation this really isn’t a boon to you because you’ve weakened your protection from risks of deflation.

Some people believe there is benefit from diversifying their currencies into foreign bonds. This may be true with other strategies but under the Permanent Portfolio there is no need to diversify your currency exposure because you own a large allocation to gold already which does this (gold is currency neutral and stands on its own). The only thing you do by owning international bonds is weaken your deflation protection in the portfolio.

I morally object to owning US Treasury Bonds. What are my other options and risks associated with them?

If you morally object to loaning money to the US Government then your primary option is to own a high quality long term corporate bond fund. Since default risk is a primary concern with owning corporate bonds, you want to make sure you only own the highest AAA rated bonds and you own them from many companies to diversify your risk against bankruptcy from a single issuer. The best way to assure this is with a high quality passively managed bond index fund. Avoid actively managed bond funds at all costs.

The Vanguard Long Term Investment Grade bond fund (Ticker: VWESX) is a good choice for an inexpensive and well run long term corporate bond index fund.

Again you must be aware that you are sacrificing your deflation protection by making this decision over using US Treasury LT bonds. See the references to 2008 above to understand the risks involved.

Where can I read more about this topic?

From the book Fail-Safe investing:

Fail-Safe Investing

UPDATED: This posting now lists (mostly) finalized 2008 total returns information (interest and dividends included) from the listed stock indices. The final numbers won’t change much. 

“The best kept secret in the investing world: Almost nothing turns out as expected.”

– Harry Browne 

Investors won’t be forgetting 2008 any time soon. Yet as bad as it was, the Permanent Portfolio survived intact with a profit for the year of about two percent.

The year included oil and other commodities going to record highs. Real estate prices fell at a rate not seen since the Great Depression. Century old banks that were leveraged to their eyeballs blew up and vanished. Iceland, a first-world country, went broke. Bernard Madoff, one of the founders of NASDAQ, admitted his hedge fund was a $50 Billion Ponzi Scheme. The Treasury Secretary and Fed Chairman openly talked about The End of The World As We Know It if we don’t “do something”. That “something” of course meant big bailouts for banks, irresponsible home buyers and automakers (and maybe more — to be continued).

By the time 2008 was over, the markets were down by one of the largest single year amounts since 1931. 

Performance Results

The results were brutal for investors in many commonly used asset classes. The numbers below include interest and dividend total returns from Morningstar:

S&P 500 -37.22%

Total Stock Market Index -36.67%

EAFE International Index -41.04%

Emerging Market Index -48.89%

Commodities Index -31.73%

Real Estate Investment Trust Index  -41.01%

High Yield Bonds -17.98%

Emerging Market Bonds  -10.29%

Treasury Inflation Protected (TIPS) Bonds -2.85%

Corporate Bonds  +2.02

International Bonds  +2.41%

Total Bond Market +5.13%

As the markets roiled the Permanent Portfolio bobbed and weaved and avoided a knockout. Here’s the breakdown of the results using commonly available ETFs and physical gold price to make up the Permanent Portfolio Allocation:

25% Vanguard Total Stock Market ETF (Ticker: VTI) -36.68%

25% iShares 1-3 Year Short Term Treasury Bond ETF (Ticker: SHY) +6.19%

25% iShares 20+ Year Long Term Treasury Bond ETF (Ticker: TLT) +33.46%

25% Gold Price appreciation for the year +4.92%

2008 End of Year Result: +1.97%

NOTE: If you used the standard Permanent Portfolio “Cash” allocation of Treasury Money Market instead of Short Term Treasury Bonds that asset is up +2.71% for the year bringing to total portfolio result to +1.10%

The best managed mutual funds (and Ivy League Endowments) in the world are down 25, 30, 40, or more than 50% in 2008. The fact that the Permanent Portfolio allocation allowed you avoid big losses in such a bad market is great and gives you a good leg up if the markets recover next year. 

Ups and Downs of 2008 Produce an Unlikely Winner

This year started off in inflation and ended in deflation. The first half saw the price of gold up 20-30% higher than it is today reaching an all time high of over $1000 an ounce (not adjusted for inflation). But by October things started to change. Gold was below where it started for the year and the stock market, which had been slowly sliding, began to really plunge. By the end of the month the damage was tremendous for investors. 

Also this year credit risk showed up in unpredictable ways. Investors who owned speculative bonds and other supposedly “safe” assets that promised higher than market returns learned first-hand that  there is no free lunch in investing . 

The winning asset this year was a surprise to just about everyone: Treasury Long Term Bonds. This stodgy asset racked up gains around 30% in a little over a month and wiped out almost all the losses in our stock holdings. This is a remarkable feat considering just months earlier all available inflation indicators were climbing at a brisk pace which is bad news for bonds. Who says bonds are boring? 

I can’t think of one prominent investing talking head or market prognosticator who was forecasting Long Term bonds were going to be the winner in 2008. Can you? 

A Theory Proven

When the Permanent Portfolio was designed, the creators based it on responding to economic cycles of prosperity, inflation, recession and deflation. Up to this point, the portfolio has endured good prosperity, bad inflation and bad recessions and has grown safely and securely. The only economic cycle it had never been through was deflation which hadn’t been a serious threat since the 1930′s Great Depression.

Well I’m happy to report that 2008 has shown the deflation protection works. While we don’t know what 2009 may bring, we now know that the portfolio weathered all economic threats it was designed to handle so far.

The Permanent Portfolio is now a veteran of all of these scenarios and came out with solid returns and excellent downside protection in turbulent markets. The portfolio helped to preserve its capital which is now available to rebalance back into stocks to take advantage of any gains that may show up going forward. 

Time to Rebalance?

One last thing: Have you rebalanced yet to harvest your gains and buy your losers? You should really think about doing that if you need to. 

Gratitude

Thank you Harry Browne, Terry Coxon and John Chandler for all the work and research you did into this investment strategy over the years. A special thanks to John Chandler who still hosts Money Talk and is keeping Harry Browne’s message of the balanced Permanent Portfolio alive (get his podcast here).  You’ve allowed many people to invest safely and sleep well at night.

Let’s hope that 2009 is kinder to investors than 2008. Happy New Year!

Buy the book and learn to make your own Permanent Portfolio. It’s the best ten bucks you’ll ever spend:

Fail-Safe Investing

Economist Robert Higgs comments in the following piece about the prospect of inflation in 2009 and beyond:

The Fed versus the Banks: Who Will Blink First?

I have never been inclined toward touting doomsday financial scenarios. I raise the possibility now only because, as I consider the situation portrayed in the graph of excess reserves linked above, I am unable to foresee how the Fed and the Treasury can navigate through these treacherous waters – waters that their own previous actions have whipped to a foam – without creating terrible financial and economic harm. If the dollar survives the ministrations of Bernanke, Paulson, Bush, and the Obama gang, its survival will be something of a miracle.

Earlier in 2008 inflation fears were the bogeyman. Oil was at $150 a barrel (it’s now $40). Gold hit $1000 an ounce (it’s now in the $800′s). And the Dollar was at record lows against the Euro and other world currencies (it recovered greatly). The markets were sure that inflation was coming on strong. 

Ahhh, but Fall 2008 came and so did the popping of the Real Estate bubble. This caused a massive destruction of paper wealth that rippled through the financial markets taking out many large banks. By December, Long Term bonds (a powerful deflation shield) swapped places with gold, commodities and other inflation hedges for being the winning asset of the year. The US Dollar shot up in value at a rate never seen against the Euro. Deflation was on everyone’s mind and Long Term bonds proved their mettle as they powered ahead with 30-40% gains. This boost erased almost all market losses in the Permanent Portfolio strategy during the October/November stock crash.

Who would have thought that we’d start 2008 with the prospect of inflation only to end the year with our illustrious central bankers scrambling to prevent an all out deflation? The markets are like that though. Moody. Random. Unpredictable. 

But what should we do now?

Stick to the plan.

If you follow the Permanent Portfolio strategy you’ve probably done OK so far considering how bad the markets are. Perhaps you’re down only a couple percent compared to the 40% loss in the general markets. You dodged a bullet and may be feeling pretty good, but don’t get complacent!

During this time as stocks swooned your Long Term bonds have soared. You are probably finding that your bond allocation is now at or above your rebalancing bands in the portfolio. They could likely be 30, 35 or even 40% of your allocation. Yet, your stocks may have fallen by 40% and could be only 15% or so of your portfolio.

That’s not good. It’s now time to rebalance. 

If you are overweight on your bonds in the portfolio (e.g. they exceed 30-35% of your holdings), you should consider selling them down to 25% and using the proceeds to bulk up the other parts of your portfolio that are below the 25% allocation band (such as your stocks, cash and gold).

For those thinking their bonds have done great and don’t intend to rebalance, all I can say is be careful. It’s tough to sell a winning asset, but at any time your bond gains could be eroded as interest rates whipsaw upwards. If economist Higgs is right, the inflation we see could be quite bad. Instead of 30-40% profits in your bonds, you could be staring at 30-40% losses or worse. 

By not rebalancing, you may miss out on large gains in your other assets by having too much of your money tied up in your current winners. Imagine missing out on a 20%, 30% or higher gain next year in stocks if the markets recover and things work out. 

YES, I know that sounds impossible right now. But it’s happened before and YES it usually does it after a bad market crash.

Gains like I just mentioned happened after the early 1970′s recession (1975 +37%, 1976 +24%), after the recession in the early 1980′s (1982 +21%, 1983 +22%), after the early 1990′s recession (1991 +31%), after the early 2000′s Internet bust (2003 +29%) and they even happened during the 1930′s Great Depression (1933 +54%, 1935 +47%, 1936 +34%, 1938 +31%).

Virtually nobody during these years was predicting a big bull market would happen right in the middle of those bad economies. Yet, they did. If you find your stocks are up +40% next year that’s great. You’ll be selling off those profits to buy your new losers. That’s the essence of rebalancing. Same for any gains in your gold or even more gains in your bonds. If the markets turn against this year’s winner at least you’ll know you took those profits off the table and put them somewhere more productive before they had a chance to vanish. 

This is not a prediction (I don’t do predictions). Just a reminder that the markets do crazy and unpredictable things so you need to own all of the Permanent Portfolio assets and not try to guess what may happen. Be unemotional about rebalancing out of winners to buy your losers. 

One final note is that taxable investors may want to take the time to do a tax loss harvest on stock funds that are underwater before the end of the year. You can use these losses to offset their taxable gains going forward. If you don’t have any losses to take, it may make sense to wait until 2009 to take the Long Term bond gains to defer the taxes until next year. Talk to your accountant to see what option makes sense. Investors in tax-deferred retirement plans don’t need to worry about this. 

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