Investing, economics, finance and random thoughts.
Posts tagged risk control
William Bernstein is Wild About Harry
Aug 29th
Investment author William Bernstein from Efficient Frontier recently wrote an article about the Permanent Portfolio:
He states:
In many respects, this allocation is a thing of beauty. Not only does it provide some protection against all but the most dire of scenarios, but its correlation grid is one rarely seen in finance: four non-derivative assets populated entirely by near-zeros…
- William Bernstein – Efficient Frontier “Wild About Harry”
He continues:
And therein lies the real problem with the TPP (ed: Theoretical Permanent Portfolio): because of its huge tracking error relative to more conventional portfolios, it attracts assets and adherents during crises, then sheds them in better times. There’s nothing wrong with Harry’s portfolio – nothing at all – but there’s everything wrong with his followers, who seem, on average, to chase performance the way dogs chase cars.
…
Sadly, this [buying assets before they have gone up in price] is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently – effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%.
- William Bernstein – Efficient Frontier “Wild About Harry”
His point about people not sticking to an investment plan is well taken, but hardly unique to the Permanent Portfolio. As for whether gold or LT bonds are a good buy now: I learned a long time ago that whenever I think I know what the markets are going to do I’m usually surprised later.
I read articles back in 2007 saying how expensive gold was when it was $600 an ounce and would crash any day now (it’s over $1200 now). I read articles over a decade ago about avoiding LT bonds because of the inevitable rise in interest rates (30 year bonds yielded 5.9% in 2000 – today they are 3.5% giving big profits to long bond holders over this time). In fact, I’ve read investment books going back over 20 years saying the exact same thing about the inevitable destruction of the long bond (30 year bonds in 1990 yielded 8.6% BTW).
The above is to say nothing of the copious amounts of doom and gloom stock predictions in 2009 that proved to be horribly incorrect as the market recovered so sharply it could give you whiplash. All of these predictions have been dead wrong and highly unprofitable if followed.
As it were, Harry Browne actually got this type of question about avoiding this or that asset over the years and I made this audio clip of him answering it:
http://crawlingroad.com/blog/wp-content/uploads/2010/01/HarryBrowne-WhichAssetWillDoBest.mp3
This clip was made in 2004 but could have been recorded last week (Browne even mentions about the Dow being 10,000 back then and it’s there again right now in fact – It’s de ja vu all over again). These debates about what to buy and sell are raging constantly in the market and will do so forever. Investors just need to ignore all of them.
The point is not to be a cheerleader for some particular asset because eventually every investment has a bad spell. It’s simply that we can’t predict the future and the reason we own different assets in the portfolio is to provide protection against the unknown.
Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out.
- William Bernstein – Efficient Frontier “Wild About Harry”
I disagree. Investors can’t possibly position their portfolio in a way to take advantage of an asset before it goes up in price. It just doesn’t happen that way.
What’s the real secret? Simple:
Just own everything at once because we have no way of knowing what is going to do best going forward.
It was investors who owned assets like gold and long bonds all the time, regardless of what was being predicted, that were able to reap these rewards the past few years. They may continue to do well, or maybe not. Maybe stocks will finally come out of their funk and go gangbusters again as they did in the 1980s and 1990s. Nobody knows.
We just don’t know when the markets will move one way or another. Investors therefore must diversify, and must stay diversified, all the time regardless of what their opinion is about the future. We simply cannot know what asset is going to do best ahead of time and allocate accordingly.
The correct strategy then is to hold fast to your asset allocation. If something has gone up enough in price to trigger a rebalancing band, then sell it down and use the profits to buy the laggards. But never time the buying or selling of an asset in the portfolio because of how you feel about it. That’s a sure way to run into big problems. The Permanent Portfolio is designed to hold volatile assets together in the form of 25% each stocks, bonds, cash and gold. If you take out any one piece you lose the protection of the portfolio.
Performance chasers will always performance chase and will always show poor results for their efforts. The Permanent Portfolio is not designed to be a hot rod so the performance chasers will eventually be disappointed. What the portfolio provides however is moderate growth with wide diversification and low volatility even in very bad markets. At the same time the strategy has shown reasonable real after-inflation returns for the level of risk involved with no market timing nor close monitoring required. For people looking for those attributes, the strategy may make you wild about Harry, too.
Assets in Isolation: Long Term Bonds
Aug 19th
Long term bonds are hot now. Posting about 20% gains so far this year.
Yep, they’ve gone up a lot. Same thing happened in 2008. In 2009 LT bonds dove in price by -22% as yields climbed from the lows of January back to the upper 4% range by the summer. Bummer. If you read what so many people say this should have been devastating. A 22% loss is just crushing, right?
No, it wasn’t.
The stock market recovered sharply that year posting around 30% gains. This effectively wiped out all of the losses in the LT bonds. If you rebalanced in 2008 taking LT bond profits and buying stocks and then taking some stock profits in 2009 to buy back into LT bonds when they fell in price you are doing perfectly fine.
In fact you’re doing better than fine because those LT bond prices have climbed again while the market this year is floating around 0%. This doesn’t even include the interest payments you’re getting. Heck, if you had just done absolutely nothing the past two years but held on for dear life you still posted small gains through the worst bear market in decades and the sharp recovery:
Portfolio 1: 60% Stocks and 40% Total Bond Market
Portfolio 2: 50% Stocks and 50% Long Term Bonds
Portfolio 3: Permanent Portfolio 25% Stocks/Bonds/Cash/Gold
Portfolio 4: 100% stocks in the Total Stock Market
CAGR 2008-2010 YTD
60/40: -1.80% / Year
50/50: +3.25% / Year
Permanent Portfolio: +5.96% / Year
100% Stocks: -7.33% / Year
For a starting balance of $10000 in 2008 you ended up with in 2010 YTD:
60/40: $9469
50/50: $11007
Permanent Portfolio: $11666
100% Stocks: $7960
The above assumes rebalancing happened each year. If you didn’t rebalance then your results were less, but still a positive return for the 50/50 portfolio and about the same for the Permanent Portfolio. Losses in the other portfolios were still present to a greater or same degree. But these returns happened even with massive losses in stocks in 2008 and massive losses in LT bonds in 2009. It’s not magic, it’s diversification in action.
It is a bad idea to look at assets in isolation. Only total portfolio value matters. Investors do not win every year in every investment. Anyone who says so is a liar. The point of having a wide diversification is so you can ride up with the winners and be protected against severe losses in the losers. If we had listened to the pundits this year about staying out of LT bonds we would have missed the gains. If we had listened to the pundits in 2009 about avoiding stocks we would have missed those gains. I see a pattern here.
Ignore the pundits and stick to the plan.
Overall, the direction of the Permanent Portfolio is heading the right way (growing each year) so there is no point in fretting over what an asset may or may not do going forward. It’s a complete waste of time even thinking about this stuff because nobody can tell what is going to happen. Stick to the rebalancing bands and buy and sell when needed. Simple.
Looking at assets in isolation is a good way to get headlines, but a terrible way to run a portfolio.
The Five Minute Rule
Aug 4th
Vanguard CEO Bill McNabb gave a speech recently about the financial markets and the need for trust. With the past few years shaking the confidence of investors, the industry has certainly been lacking in the trust department.
In this speech CEO McNabb gives out three important points about investing that are critical:
1) Simplicity – Investments should be simple to understand.
2) Transparency – Investment vehicles should be transparent so all moving parts are understood.
3) Candor – Investors and advisors should be honest with each other about the risks in an investment.
His point on simplicity matches up very closely to one of the 16 Golden Rules of Investing. That is, never invest in something you don’t understand completely:
A great rule in investing is the five-minute rule: If you don’t understand an investment in five minutes or less, take a pass. This should apply to sophisticated investors, novices opening their first accounts, and everyone in between. – Bill McNabb, Vanguard CEO on Restoring Investor’s Trust
Very wise counsel! A complicated investment can conceal many dangers. All investments have risks, but as investors we must be certain we understand each risk as best as possible. Having unknown risks buried in a complicated and opaque investment scheme is bound to cause problems eventually.
Remember this: There is no shame passing on an investment you don’t understand. I have done it myself many times in the past and have never regretted it.
Simplicity is critical to investing success and this can’t be stated often enough. The Five Minute Rule is a great way to weed out bad investments and keep things simple.
Gold “Bubble”
Jun 27th
There’s much discussion in the news about Gold’s new price high (about $1300). The word “bubble” is getting tossed around a lot. There are a flood of articles (and advertisements) about buying gold and an equal flood about selling gold. What to do?
Talks about gold seem to devolve into market timing arguments. But for someone holding gold as part of their total asset allocation, such as the Permanent Portfolio, it should be treated like stocks or bonds with no market timing involved.
The only reason to be timing the market with gold is if you are treating it as a speculation. In this case it’s no different than relying on various indicators to sell out of all your stocks or sell out of all your bonds, etc. So use what you feel is best because they are all equally unreliable as market timing doesn’t work.
I can recall seeing these gold conversations when it hit $600 an ounce. I recall them when it hit $850 an ounce (matching the high in 1981). I can recall them when it hit $1000 an ounce. I can recall them when it hit $1100 an ounce. And of course I am seeing them all over as gold hovers near $1300 an ounce. The price of gold could fall at any time, but then again it could just keep going up responding to world events. We have no way of knowing these things.
If you own gold in your portfolio already then be sure you keep it rebalanced and use the profits to buy your laggards. If you don’t own it already, be sure you are doing so with a logical plan in place why you are doing it and not some knee jerk reaction to what you are seeing in the news.
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This topic is being discussed on the forum.
Book Review – Books on Risk (and two podcasts)
Jan 28th
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.
Next, there is Nassim Nicholas Taleb and his series of books on chance. First there was Fooled By Randomness followed by The Black Swan. Both of these books explore the idea of unpredictability in the world. While his advice is largely being linked to finance today (he was a former trader), his observations come into play in many areas of life. His book, The Black Swan, pre-dated the 2008 crash involving Fannie Mae but said this in one of his footnotes:…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.
Stock and Bond Only Portfolios: A Flawed Approach
Dec 20th
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. More >
Direct Bond Ownership vs. Bond Funds
Dec 16th
A reader asked about why it’s recommended investors own their Long Term Treasury Bonds directly for the Permanent Portfolio allocation vs. using a mutual fund.
Two words: Manager Risk
This is the idea that the people managing your investments can make decisions that hurt performance out of bad luck or recklessness. Remember: Nobody cares more about your money than you do.
The bond allocation for the Permanent Portfolio says that 25% of your money should be in US Treasury Long Term Bonds. These bonds offer low credit risk as the US Government can always tax people to pay creditors or (worst case) print money to cover the payments. That makes them the safest type of bond US investors can own. They are much safer than corporate bonds and municipal bonds.
This matters because you can buy and hold Treasury Bonds directly and not have to worry about the risks other bonds pose. When you own Treasury Bonds directly your money is under your control and you know exactly how it is being used. Further, you save money as you aren’t paying a fund manager a fee to own such low risk bonds for you.
Now, let’s consider bond funds vs. owning bonds directly. Fund managers often have leeway in how money is deployed if you read the fund’s prospectus. This is important for something like the Permanent Portfolio whose strategy relies on the investor to hold US Treasury Long Term Bonds with no credit risk at all times. You don’t want managers in your bond fund moving things around based on what they think the market will do. This can blow the protection of your bond allocation to pieces if they make a wrong call. You also don’t want them swapping out your ultra-safe Treasury Bonds with less safe securities in an attempt to boost returns. This can also get you into big trouble as we’ll explore below.