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.

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.

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 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.

I’ve read fund prospectuses from various “Treasury” bond funds that were loaded with non-Treasury securities. For instance, the Vanguard Long Term Treasury Bond Fund will hold a minimum of 80% in US Treasury bonds and the remaining 20% can be government agency bonds, repurchase agreements , and even mortgages!

Here is what the fund says specifically:

The fund invests at least 80% of its assets in U.S. Treasury securities, which include bills, bonds, and notes issued by the U.S. Treasury. The fund is expected to maintain a dollar-weighted average maturity of 15 to 30 years.

• The fund reserves the right to invest in repurchase agreements, contracts in which a bank or securities dealer sells government securities and agrees to repurchase them on a specific date and at a specific price.
• The fund may invest in futures and options contracts, which are traditional types of derivatives, when they allow a transaction to be completed at a better price than by purchasing actual bonds. However, the market value of futures contracts will not constitute more than 20% of the fund’s assets.
• The fund reserves the right to invest, to a limited extent, in collateralized mortgage obligations, which are moderately vulnerable to mortgage prepayment risk.
• The fund may lend its investment securities to qualified institutional investors for the purpose of realizing additional income.

(emphasis added)

This fund is not 100% Treasuries at all as the name would imply. It’s at best 80% Treasury and you are relying on the managers of the fund to make good calls on the other 20% of the assets.

Personally, I get jittery when fund managers start doing cute things that differ significantly from the job I hired them to do. In my mind, the job of a Treasury Bond Fund should be to hold only Treasury Bonds. If I wanted to own mortgages I’d go out and buy a fund that owns them. I also am not interested in loaning out my bonds to realize additional income. If I wanted additional income I would have bought riskier bonds that paid more interest (realizing that I’m taking on more risk). Some of these other activities they are engaging in are vague enough to raise further questions as well in terms of risk.

But this is Vanguard – The premier index investing company. These bond managers can’t possibly make mistakes, right?

Well in 2002 the managers of the Vanguard Total Bond Market index fund had events go sour on them when WorldCom and Enron ran into problems (largest bankruptcies in US history at the time). The fund ended up lagging the index for that year and it should serve as a warning to those who believe that fund managers can’t make mistakes.

As stated in their 2002 Index Bond Funds Report Pg. 5:

At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies.

(emphasis added)

All I can say is if mistakes like this can happen at Vanguard they can happen anywhere.

Yet, Vanguard is saintly compared to others. In 2008 there were bond funds that lost 30% or more in value when the credit crisis happened. Investors in these funds took large losses when they thought what they had were safe bonds. You just can’t read the name of a fund and assume what’s going on inside it. You have to read the fine print.

If you own your Treasury Bonds directly you need not worry about any of this. You are in control and aren’t going to take unnecessary risks. Are you going to purchase futures contracts instead of actual Treasury Bonds? No. Are you suddenly going to wager a portion of your money on higher yielding government agency bonds that are not guaranteed by the Full Faith and Credit of the US Government? No. Are you going to wake up one day to see that the US Treasury Bonds you owned are now collateralized mortgage obligations? No. You’re going to be holding 100% Treasury bonds in your own account and don’t have to worry if someone is doing something risky with your money.

If you can’t own bonds directly due to your own circumstances (such as a retirement plan that doesn’t allow it), or you just don’t feel comfortable managing them, then iShares Treasury Long Term Bond ETF (Ticker: TLT) is something to consider. This is a reasonable alternative to direct ownership (although it can never be as safe as direct ownership) and holds nearly 100% of their funds in Long Term US Treasury Bonds. Their prospectus gives them only a little leeway to go outside of this basic mission.

If you can’t get TLT then use the Vanguard Long Term Treasury Bond fund (Ticker: VUSTX). It’s better than most despite its warts (although I think Vanguard should adopt a strategy similar to iShares TLT and knock it off with this other stuff they are doing). Fidelity’s Spartan Long Term Treasury Bond Fund (Ticker: FLBIX) appears comparable to Vanguard and perhaps a little better as they try to stick to Treasury Bonds exclusively. After that, I recommend you do your own careful research before investing in any bond fund. The preference is, as always, to have a fund that only holds Treasury Bonds and is not shifting around maturities with active management. By the way, a fund with the word “Federal” in the name may not be Treasury Bonds either. It could be loaded up with government agency bonds which may or may not have the Full Faith and Credit guarantee of the US Treasury. These agency bonds are not the same as Treasury Bonds and shouldn’t be confused with them.

An exception: If you can’t buy Treasury bonds directly, can’t own them through a fund, or have objections to owning Treasury bonds on ethical grounds, then you probably should use a fund – A cheap long term corporate bond index fund. Why? Because non-Treasury bonds all have credit risk and you need to spread your money out as far as possible to prevent taking a serious loss on a concentrated bet if the company issuing the bond goes kaput. In this case, you should use an index fund with the lowest possible costs you can find. Look into the Vanguard products for a corporate bond fund that holds long term bonds. These types of funds hold bonds from many different companies to spread out the risk. This is not as good as owning Treasury bonds, but if that’s all you can do it’s better than not owning any bonds.

To close, own Treasury Bonds directly if you can. If you can’t, then try your best to find an inexpensive index fund that holds as much in long term Treasury Bonds as possible without too much monkey business going on behind the scenes. You may have to roll up your sleeves and read the dry prospectus, but it really will be well worth your time (and money) to know what your bond fund is doing under the covers.

If you want some no-nonsense ways to own Gold you can read my FAQ:

Gold FAQ

People are wondering about the gold price. Is it going to go higher? Is it going to go lower? Etc. Well the unexciting answer is nobody knows. That’s right, nobody at all knows. I don’t care how pretty their charts are or what logical arguments they have for or against. What I do know is that too many people are talking about the stuff.

If you own gold as part of your Permanent Portfolio allocation then you should stick to your plan and rebalance when it is needed. However, I would not go out and buy gold for my speculative Variable Portfolio bets right now.

I don’t think any particular asset class looks like a great buy for a Variable Portfolio speculation. So personally I’d just stick to the four way Permanent Portfolio split and not do much gambling with my money.

Now if you own gold in your Permanent Portfolio again I’d say to stick to the plan. That means you have a rebalancing band of either a low of 15% and high of 35% or a low of 20% and high of 30%, etc. If you are at or above your band then you should sell down your gold and rebalance the proceeds into your lagging assets.

Yes, I know it’s hard when you read all the doom and gloom but you have to do it. The point is you take an asset everyone wants and sell it to buy something that less people want.

The Permanent Portfolio is designed to limit risks and perform contrary buys and sells in the market. At any one time you probably are going to have an asset doing very poorly and another doing very well. This is how it is designed to work. But you need to be sure you do your part. That means selling down assets when they are doing great and using the money to buy the things people don’t want to touch at the time.

You hear that term “Bubble” being overused a lot now? “Gold Bubble”, “Stock Bubble”, “Bond Bubble”, “Bubble Bubble”. Well the way you limit losses due to “bubbles” is by rebalancing. No elaborate market timing is needed. If you own too much, you sell it down until you own less of it and buy something else. Simple stuff.

Are you nervous about the rise in gold prices and all the hype? Well I know some people are because I’ve heard about it. Here’s my advice:

If you have a rebalancing band that is 35% and your gold has risen to, for example, 33% of your allocation then perhaps you can sell it down early to 25% and re-deploy the money. I don’t think selling early in your rebalancing bands is going to hurt you much if it makes you sleep better at night. Perhaps in the future you make your rebalancing bands the 20%/30% thresholds so you keep a tighter control over how much money you have at risk in each asset. This can incur added tax and brokerage fees you need to be aware of, but it’s not terrible if it makes you feel comfortable. Remember, this isn’t a science so there are no precise answers to be had.

The one thing I would not do though is let any allocation slice rise above 35%. If you sell out too early and harvest those profits you will be OK. Sure you’ve not milked out the very top of something. But, as they say, only liars sell out at the very top and buy at the very bottom. But if you wait and let an allocation go to 40%, 45%, 50%, etc. you can set yourself up to take a tremendous loss if the markets turn suddenly. This isn’t just a warning for gold, it’s a warning for any asset class you hold.

This is just a reminder to not make gold a religion and use it intelligently in a portfolio. I don’t know what the gold price is going to do, but I don’t think you should listen to all the hype in the news about it either. Stick to your plan and don’t take risks with money you can’t afford to lose.

You can learn things from the most unlikely sources. When people ask me what it was that got me to start following the Permanent Portfolio I respond with one word: Porn.

Yes, porn. I relate to you the story below that kicked me into gear to re-assess my portfolio strategy and risks I was taking several years ago. This is what got me to discover and start using the Permanent Portfolio allocation strategy.

I was buying some used welding gear off of Craigslist in late 2006(??) and go to this guy’s shop to look at what he had. We strike up a conversation and he tells me that he produces Adult Films but was getting out of the business (his shop had lots of light rigging and camera gear so I had no reason to doubt him). “Why are you doing that?” I ask. Because you’d think that making adult films is probably quite lucrative. I don’t know this, just a suspicion. He replies “I’m going into Real Estate!” He then spends the next 30 minutes telling me about flipping houses, second mortgages, zero down loans, etc. I just sit there and nod my head, buy the stuff he had for sale, and leave.

This bugged me because everyone was talking about Real Estate then and now I meet a porn producer going into it? It was just too much. On the way home I call my wife and say: “Honey, we’re going to sell everything we own relating to real estate. REITs, mortgage bonds, anything holding mortgages, etc. I’m then going to re-evaluate our portfolio from the ground up.”

I’m not a market timer, but that’s what I did. I call it a “Shoe Shine Boy” moment. A phrase I use that relates to a story where a famous investor (Joe Kennedy I’ve been told) was getting his shoes shined in 1929 and the shine boy kept giving him hot stock tips. He immediately went back to his office and sold all his stocks to avoid the big crash later that year. He figured that when the shine boy is giving you stock advice it’s time to get the heck out.

I sold everything that had real estate in it. I also sold all bond funds that had any type of credit risk. I had been an indexer for some years at that point so I knew I wanted an indexing strategy as active stock management just doesn’t work. Yet, I never felt comfortable with the claims of many about how you could own a bunch of stock index funds and take credit risk with bonds and have diversification. It was time I looked into the matter myself without any prejudices.

I looked at all the options and researched everything with a fresh take towards risk and uncertainty. Nothing was off the table no matter how it conflicted with what I’ve read before. Eventually, I ended up with the Permanent Portfolio after loads of research and scrutinizing of the approach.

The biggest thing about this experience is not that it helped me avoid a bad loss (which really was just sheer luck). It’s that it made me seriously explore what risks I was taking with my portfolio and how those risks were being counter-balanced with other assets I own. You can’t invest without risk. But it’s important to be sure you know what risks you are taking and how they can affect your life savings if they ever show up. It took a porn producer to get me to go back and evaluate these things. Life is strange.

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: