I’m often asked questions about substituting some asset X for one of the other assets in the Permanent Portfolio. I think this is a bad idea because you could introduce a potentially weaker investment for one of the time-tested assets the portfolio holds.

Now, as a recap we know that the Permanent Portfolio holds four core assets:

1) Stocks in an inexpensive broadly based index fund like the Total Stock Market Wilshire 5000 or Russell 3000
2) US Treasury Long Term Bonds
3) Cash in a US Treasury Money Market fund
4) Gold bullion

So why does the Permanent Portfolio hold these specific assets? Why not some of the new stuff being sold by Wall Street each year? Or some of that other stuff being pawned off as the hottest new fad by some academic and the book they’ve written?

Well, this is primarily because the goal of the portfolio strategy is to grow money when it can and protect that money when it can’t. To do this, the Permanent Portfolio owns a variety of assets which are best in their class for each particular economic condition (prosperity, inflation, deflation and recession) and do not take any risks outside of the area they specialize in. These assets have proven themselves a number of times in the past to do exactly what they say they will do. This lessens the chance that you’ll be surprised by some unforeseen risk.

What is meant by this is that the portfolio holds stocks in a cheap and broadly diversified index fund free and clear with no margin (leverage). Broadly based stock index funds have an excellent track record compared to actively managed funds and do well when prosperity is driving the markets. This means you are only taking market risk with the stocks and not additional risks of being unable to service your margin loan forcing you to liquidate your portfolio for a margin call in an emergency. Nor are you taking on risk that a stock fund manager may have you out of the market when there is a big rally going on forcing you to miss the gains.

For bonds we are taking on interest rate risk by owning long term Treasuries. However we are not taking on credit and call risk present in other bonds. This means if a deflation situation hits we can profit from the rise in Treasury prices but not have to be concerned with the resulting bad economy that could cause non-Treasury bonds to default. Neither do we need to worry about the low interest rates that could make bond issuers recall their bonds and sell new ones that are cheaper for them. It also means that during times of prosperity we have a nice steady income stream from the bond interest to add to our stock gains.

For our cash we hold only a Treasury Market Fund because they also have no credit risk. But they also eliminate needing to rely on FDIC insurance limits and liquidity issues that could affect non-Treasury securities and money market funds as we experienced in 2008. You will always be able to access your cash if you own Treasury bills in a money market fund because they are the most liquid paper investment on the planet. You never have to worry about a non-Treasury money market fund freezing redemptions because they broke the buck due to their bad investment decisions (also happened in 2008). Nor do you need to worry about your bank going under and wondering how long it will take FDIC to clean up the mess and allow depositors to access their money.

Finally we have gold which can suffer malaise during times of a good market but is the most powerful asset you could possibly own during a period of bad inflation. Gold also functions as an ultimate insurance policy in case something truly awful were to happen to the US Dollar.

These assets were chosen for specific performance reasons because they tend to combine in a way where risks in one are cancelled out by benefits of another. Interest rate risk in bonds are cancelled out by the inflation performance of gold. Gold price declines are cancelled out by stock and bond price gains. Stock market losses can be countered by gold or bond price increases. Etc. Risks are taken where they should be taken and avoided where they should be avoided.

When you substitute a lesser quality asset for one of the rock stars the portfolio already owns you can seriously damage the diversification potential in unpredictable ways. So my advice is to leave the core portfolio alone. The only real exception to this are for foreign users of the portfolio strategy who should be holding their cash, bonds and probably more stock in their home country to be sure their portfolio is in sync with their local economic climate and not tied so close to the US and US dollar.

If you want to add other assets then you can do it by holding them in your variable portfolio for money you can afford to lose. But I think changing around the core assets is not a good idea.

At this point we have about 40 years of data showing the strategy has been working. A full thirty years of that data is actual empirical evidence. This is because this portfolio strategy was conceived in the late 1970s with only minor tweaks into the 1980s and largely unchanged since. The worst loss the portfolio had was about -4-6% in 1981. There are no guarantees going forward of course because the past does not predict the future, but the portfolio theory works as designed so far and has a really solid record of performance and safety. So why do you want to go in and mess around with something that has been shown to work in good markets, inflationary markets, deflationary markets and everything in between?

I say if it ain’t broke, don’t fix it. Keep it simple.

A theme you’ll hear on this blog about investing is the idea that the markets are not predictable. You may believe that I’m referring to the idea that you can’t predict returns on investments ahead of time and that’s partially true. The other part though relates to extreme risks that sweep through the markets in unpredictable ways with unpredictable results.

Aside from standard market risks, when you look at your investments it’s also important to always ask yourself: “What if I’m wrong?” Because, odds are, you will be wrong eventually. It’s just a question of degrees on how wrong it will be: A little or a lot.

The Permanent Portfolio has protection against unpredictable market risks and being wrong. If you’re wrong, you’re not going to be wrong so much that you take a crushing blow to your portfolio (because your asset allocation is widely diversified in relatively small chunks). We should also understand though that all investments have risk. Without risk, you will not get rewards. So risk must be taken to grow a portfolio, but it must be done with specific goals in mind. We need profits, but we also need defenses against an unknown future.

In this light, I’d like to share with you some books and podcasts that I think really hit at this problem of risk, uncertain futures and protecting yourself against being wrong. They may help you understand why diversifying and eliminating unnecessary risks in your portfolio is so important and why being wrong does not have to be fatal if you handle it correctly.

First there is John Allen Paulos and his book A Mathematician Plays The Stock Market. This 2003 title is one of a series of excellent books written about his worldly observations as a mathematician. In this case, the book details his own personal story of losing money in the stock market and how uncertainty rules. It’s an interesting look at many concepts you see in the investing world with respect to stocks vs. bonds, efficient market hypothesis, chaos theory, etc. And, best of all, it’s a very easy and fun read with almost no math but high level explanations of many concepts with real-world examples. He has a number of books written in his “A Mathematician” series exploring everything from innumeracy in society to his experiences investing (and losing) lots of money in Worldcom as he discusses in this book. The bottom line is that risk is real, markets are random, and trying to beat it can be very costly. His dedication reads:

To my father, who never played the market and knew little about probability, yet understood one of the prime lessons of both. “Uncertainty,” he would say, “is the only certainty there is, and knowing how to live with insecurity is the only security.”

John Allen Paulos – A Mathematician Plays the Stock Market Dedication

Now that’s a dedication I can get behind! That is the core philosophy of how the Permanent Portfolio is designed to operate.

…the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events “unlikely.”

Nassim Taleb – The Black Swan Pg. 225

I’d say he certainly called that one correctly.

I also think you’ll enjoy these two podcasts from Nassim Taleb. One recorded in 2007 talks about his book The Black Swan. The second was recorded in 2009 after the market meltdown as an after-action report on what he had written and said before:

Taleb on Black Swans – April 30, 2007

Taleb on the Financial Crisis – March 23, 2009

One thing about Taleb is while he has disdain for most fields of economics (and especially the very silly Keynesians), he does have an affinity for the Austrian Economic School and their dislike of the over-application of mathematics in economics for what is, essentially, a human behavioral problem (aka. scientism). Why does this matter? For one, you cannot model risks accurately with standard statistical methods because human behavior is not predictable. Secondly, Harry Browne was a firm believer in Austrian Economics and the Permanent Portfolio design, at its absolute core, is based on the Austrian School’s theory on monetary cycles (a lengthy topic for another day) and embracing unpredictability in the world. In fact, I think that one of the reasons the Permanent Portfolio is good at dealing with market risk is because the Austrian Economics school is right about a great many things. This outlook helps to drive the portfolio down the right path over time avoiding serious pitfalls and dangerous assumptions about the future.

With these three books and two podcasts you will understand more about market risk than most professional investors and economists. Seriously. Combine that with Harry Browne’s podcasts, and his own previous books, and you’ll be well versed in the dangers of the unpredictable in the investing world and how to position yourself to deal with them.

Fail-Safe Investing

I get asked from time to time about what asset class in the Permanent Portfolio is going to do best. Usually this is in the context of someone wanting to start investing in the Permanent Portfolio but they don’t want to buy the stocks or the bonds or the cash or the gold because they feel one or all of them are too expensive.

Well, here is a snippet from Harry Browne’s investment radio show on October, 24th, 2004 where he answers the same question from a listener about not wanting to buy Asset X because it’s too expensive (in this case stocks and bonds). Harry Browne lays out his experience on the matter in this five minute long clip:

Harry Browne – Which Asset Will Do Best

It’s now 2010 and this show was recorded in 2004. Let’s see what happened if the caller just took their money and dumped it into the 4×25 Permanent Portfolio split instead of trying to guess what the market would do:

2004-2009 annualized return of each individual asset class (rounded to nearest tenth from Simba’s Spreadsheet*):

Stocks: 2.5%

Bonds: 5.8%

Cash: 2.5%

Gold: 17.5%

Annualized return for 4 x 25 split portfolio: +7.5-7.8% (depending on bond index used)

We know gold did well after the fact but don’t know how it will do going forward. Back in 2004 it was a rare bird who was telling people to buy gold and many analysts still liked stocks as they were recovering from the 2000-2002 crash. Indeed, from 2004-2007 stocks were up about 10% a year. In fact, investors who thought stocks were a bad bet in 2004 were probably feeling pretty left out by 2007 after seeing them go up so much in price. They likely were tempted to move their money into stocks at that point – just in time to catch the downswing. Then, we have 2008 where bonds went up over 30% in a single year due to the market panic and handily beat stocks over this 2004-2009 time period as well. On top of all this, consider that the nearly 8% annualized return also included the horrible 2008 performance for stocks and poor 2009 performance for the bonds. If we go year by year in fact, returns for these assets will be all over the map from double digit boom years to double digit down years. Yet, there was still a reasonable profit made.

This illustrates why investors should always keep a balanced and diversified portfolio and not try to guess what the markets are going to do. In this case, the listener above would have pulled down about 8% a year doing pretty much nothing but holding a diversified portfolio and they would have rode through the 2008 crash without  any damage. This would have been a far safer portfolio than making a concentrated investment in a single asset like gold or stocks regardless of how the actual bet turned out over the past – A bet that could blow up just as easily going forward.

Harry Browne’s archived shows contain lots of wisdom and knowledge like the above that have proven to be solid and dependable. I advise those looking to implement the Permanent Portfolio strategy to take the time to listen to Harry Browne’s radio shows as well as buying his book Fail-Safe Investing. I don’t make any money from this and it’s less than 10 bucks. This is an outstanding way to educate yourself on the approach and see if it is something that will work for you. Even better, his shows are timeless and you’ll probably hear people calling or writing in with many of the same questions you have. It’s entertaining and educational to listen to what people were saying and worrying about six years ago and how little it’s changed. Moreover, it helps reinforce the idea that the future is not predictable and investors should use strategies like the Permanent Portfolio that embraces this uncertainty so they can grow their money safely.

* I use historical data to disprove investment concepts as history cannot show you what returns will be going forward. I’d advise anyone using backtested data to not fall into the trap of building optimized portfolios that worked in the past. The past does not repeat and highly optimized and data-mined assets that outperformed before may not do so in the future.

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

A poster on the Diehards forum remarks that today is the 80th Anniversary of Black Monday 1929 – The Great Stock Crash that touched off the Great Depression. In this very interesting video you can hear first hand accounts of the events that led up to the crash:

Blog reader Kyle sent me some information on a new gold ETF trading under the symbol SGOL. This ETF is a gold bullion ETF similar to the Street Tracks and iShares gold ETFS (Ticker: GLD and Ticker: IAU).

What makes this ETF different is SGOL’s gold is stored in Swiss bank vaults and not US financial centers. Since part of the Permanent Portfolio concept is to have some assets geographically diversified this could be an advantage. The expense ratio of this ETF is also very competitive as well at 0.39% which is right in line with the other offerings.

Now, some worry about a remote risk of US gold confiscation happening again in the future and this ETF would probably not prevent that (the govt. could simply pass an order requiring repatriation of funds for instance which would accomplish the same thing). However, this does give you a place for your assets that may not be open to the same type of risks as gold stored in the US. Risks such as from terrorist attacks, natural disasters, cyber attack, civil unrest, etc.

On the other hand, I’m not sure how if your US-based brokerage is having problems due to these issues here that it wouldn’t impact your ability to prove ownership in SGOL. Well, it’s a start at least.

This fund is brand new and I’m not one to jump into new financial products so I may give it time to build up some momentum. However, it’s something to consider for those that want to build a Permanent Portfolio and use ETFs for the gold portion but would like to have a modicum of geographic diversification.

Thanks again to Kyle for the tip.

An interview with Rob Arnott describes the portfolio of Jacob Fugger (“Fugger the Rich”) who lived from 1459-1525. The portfolio that made him so rich sounded very familiar and I wanted to share this part of the interview with Mr. Arnott:

Rob Arnott: Where do we go from here?

Audience Question: It seems you’re simply promoting a diversified approach to investing. How is this different than basic portfolio theory?

Arnott: There’s nothing new under the sun. Questions: How many people follow a truly diversified approach? How many think of their stocks as ownership of an enterprise (à la Graham & Dodd), rather than as some assemblage of portfolio characteristics? In the 15^th century, Jacob Fugger (“Fugger the rich”) put his money in shares, in loans (bonds), in property and in commodities. And he’d rebalance when the mix drifted away from one-fourth each. The shares and the real estate did well when the economy was strong; the loans and commodities did well when it was weak; the commodities and real estate did well when the government was debasing the currency; and the stocks and bonds did well when the government and the currency were sound. Old ideas have a lot of power, and keep getting rediscovered.

(emphasis added)

Here’s another quote that I’ve seen attributed to Fugger in numerous places (Although none referenced the original source. If you know of it, please let me know.):

“Divide your fortune into four equal parts: stocks, real estate, bonds and gold coins. Be prepared to lose on one of them most of the time. During inflation, you will lose on bonds and win on gold and real estate; during deflation, you lose on real estate and win on bonds, while your stocks will see you through both periods, though in a mixed fashion. Whenever performance differences cause a major imbalance, rebalance your fortunes back the four equal parts.” (emphasis added)

- Jacob Fugger

I found it amazing that Fugger’s portfolio was so close to the 25% split that the Permanent Portfolio uses (Was this the inspiration or a rediscovery? We’ll never know.). Although, real estate is something the Permanent Portfolio avoids due to the illiquid nature of the asset and holds cash instead (if you own real estate, count it as part of your Variable Portfolio).

Note how Fugger’s approach sounds very similar to the Permanent Portfolio’s idea of holding assets that correlate to economic cycles of Prosperity, Inflation, Deflation and Recession. This insight is something that is missing from most portfolio allocation advice you see. Further, it’s also why many portfolios get blindsided by extreme events or protracted periods of underperformance in my opinion.

Now here’s something in Fugger’s quote that many people have a problem with:

Be prepared to lose on one of them [an investment] most of the time.

I get questions about some asset being too high and something being so bad that they couldn’t possibly go out and buy it. Yep. That’s pretty much how it always works. Here’s my official response:

Don’t look at asset classes in isolation. Look at your portfolio as a whole instead.

What do I mean by that? Well, it doesn’t matter if you lose 10% on an asset in a year if your total portfolio has gained in value. A 10% loss in gold but a 25% gain in stocks and bonds puts you ahead. A 20% loss in stocks but 30% gain in bonds also puts you ahead. The individual losses were offset by the winners enough to give you a profit in the total portfolio.

As it is, the Permanent Portfolio is designed to hold assets that are volatile so a decrease in one is almost always offset with gains in another. At any point in time you’re going to have something in the portfolio that is really hot and something that is a real dog. It’s almost guaranteed too happen. Why? Because the economic environments of prosperity, inflation, deflation and recession will never happen all at once. Since the assets are geared towards responding to these conditions individually you are going to have something that is always doing well and something that isn’t. It’s just the nature of the diversification.

The problem is that since we can’t predict the future we don’t know what asset is going to do well and what is going to do poorly ahead of time. So our solution is simple: We own them all no matter what.

If you don’t own all the assets, all the time, you don’t have the protection of the portfolio. It’s just that simple. You also need the guts to rebalance out of your winners and buy your losers. Something that has been talked about here in the past.

It looks like Fugger had this pegged a long time ago which is why he was Fugger The Rich and not Fugger The Pauper. It’s comforting to know that good ideas really are timeless.