Posts tagged Inflation
Permanent Portfolio 25% Gold Allocation FAQ
Oct 13th
This FAQ will be updated from time to time. I didn’t think it would be as involved to write as the other FAQs on Stocks, Bonds and Cash. What I found though is that there is just so much misconception about gold (both pro and con) that it needs a lot more detail. This FAQ is huge. It probably needs to be broken out. But I figured I’d post it all now because it’s been months since I promised it and if I wait until it is “done” then it could be many more months.
So this is a work in progress and will be updated as I get around to it.
Last Updated: November 19th, 2009
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% gold allocation and how it protects you from inflation and other currency problems.
Gold vs. Collateralized Commodity Futures
Jan 27th
The Permanent Portfolio uses gold as its primary protection against inflation. Recently there has been a lot of promotion about Collateralized Commodity Futures (CCFs) from companies like Pimco. The claim is CCFs provide better inflation and unexpected event insurance for portfolios than gold and other hard assets. I think this is simply a marketing claim that has many problems.
In response to an article that Larry Swedroe wrote called All That Glitters is Not Gold I present a short list of why Gold is better than CCFs for high inflation and other currency crisis protection:
1) He is data mining from a period of time when gold was at speculative peak to make his point. I can pick any investment asset (stocks, bonds, etc.) and do the same thing to make any of them look bad.
2) He fails to consider the market conditions at the time that may have been driving the high price in gold. For instance, the Prime Rate was 20% in the early 80’s and 30 year mortgages in the mid-high teens. Who’s to say the dollar wouldn’t have kept falling if the Fed didn’t finally get a handle on things?
3) He’s not looking at how the asset does in a diversified portfolio but looking at it in isolation. Diversification only works when you hold multiple uncorrelated assets together. It doesn’t work when you concentrate your bets because if you’re wrong you can take tremendous losses. If you concentrate your bets on stocks, bonds, cash, real estate, etc. you can and will have the same problem of too much risk.
4) He’s working with piles of simulated data on CCFs to draw his conclusions against an asset (gold) that actually existed. Gold has been tested under high inflation and currency debasement conditions for thousands of years in countless countries. Many CCF funds have been around only six years based on only about 40 years worth of data for their simulated backtested performance numbers.
5) Treasury Inflation Protected Securities (TIPS) have been around for only about 10 years in this country (since 1997). They are a completely unproven high inflation hedge. He assumes that they are going to respond well to high inflation when in fact nobody really knows what they’ll do compared to gold. At the minimum, even if TIPS keep up with inflation they will not go up enough in value to offset the impacts of inflation in your other investments (unlike gold which has done this in the past).
6) Physical gold ownership has no counter-party risk and is very easy to understand compared to complicated and opaque CCF funds. CCF funds could be engaging in activity behind the scenes that puts you at risk but you may never even know.
7) Gold is a commodity, but is also a monetary metal. So you get the protection of commodity ownership but also the protection during financial crises that are threatening the currency.
8 ) CCF funds are expensive and tax inefficient compared to gold. Gold ownership usually includes a small storage and insurance fee unless you hold it yourself. Other than that it generates no taxable events until it is sold.
9) As 2008 has shown, when banks are teetering on collapse people are happy to hold gold to hedge the risks but are not happy to hold CCF funds which were brutally wrecked. Gold was up 5% in 2008 and CCF funds were down over 50%!
Gold is far better as a hard asset over commodity funds. It is easy to understand, easy to buy, easy to sell and reacts strongly to conditions that are bad for many other investments (such as high inflation). If you are going to purchase a hard asset for your portfolio (as the Permanent Portfolio does) then you should only buy gold and leave the commodity futures funds alone.
Permanent Portfolio Results 2008 – A Disaster Averted
Jan 1st
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.
Time to Rebalance?
Dec 29th
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?
Terry Coxon Discusses the Possibility of High Inflation
Dec 21st
Terry Coxon, co-creator of the Permanent Portfolio, discusses the possibility of high inflation as the US economy stagnates. Is it possible? Sure. The Fed is biased towards creating inflation because that’s what they were designed to do. Their worst fear is deflation because their tools are so limited. In my opinion, they will continue to try to inflate the dollar to force people to spend money. They’ll worry about the inflation it causes later.
Will it work? Hard to say. It didn’t work in Japan for the past 20 years and may not work here. Economics is just as much about psychology as anything else. If people don’t want to spend money and take on new debt it’s hard to force them to.
People often wonder why the Permanent Portfolio holds a 25% gold allocation at all times. After all, isn’t gold a zero real return asset? Well, this is the reason. If bad inflation comes the other components of the portfolio will do poorly, but the gold will react so strongly that it’s likely all the other losses will be overcome. But what about a deflationary situation and these predictions of inflation are wrong? Well, the portfolio holds 25% in Long Term Treasury bonds which will do very well under that scenario.
The Permanent Portfolio Allocation
Dec 18th
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:
- Prosperity
- Inflation
- Deflation
- Recession
Can high inflation save the economy?
Dec 11th
An article in Forbes magazine tries to make the case for devaluing the dollar by 40% to help out the economy:
Why not attack the situation in a manner that will benefit most everyone, an approach that has been successful before and, when compared to the current course, has little downside? Here it is. Stand back. World currencies should be devalued overnight.
The Forbes article is riddled with errors about inflation and the gold standard that I won’t address in this post. The short of it is that devaluing the dollar by 40% won’t do anything at all except force the prices of everything else in the market up by 40% overnight as businesses move to protect themselves. It would also drive interest rates on loans through the roof, put many companies into bankruptcy, wipe out huge portions of savings of the average American and make a bad economy much, much worse.
So what if? After all, this is Forbes Magazine discussing the idea so someone thinks it’s good. How would you want to position your finances if the threat of a massive inflation to solve our problems came to pass?