The Permanent Portfolio, Investing, Finance and Random Thoughts.
Posts tagged risk management
Analysis of the Icelandic Economic Collapse of 2008
The Mises Institute just released an e-book analyzing the root causes of the economic collapse in Iceland in 2008. I have just started reading it, but the authors are building a case of the usual suspects (Central Banks, fiat currency and economic planners) behind the debacle:
Deep Freeze: Iceland’s Economic Collapse
Failure analysis is an important part of learning. And, it’s cheaper to learn from other’s mistakes than to repeat them yourself. I like reading about these kinds of extreme events and what measures did and didn’t work to protect investment capital. As it were, Marc DeMesel did an analysis of how the Permanent Portfolio would have performed for Icelandic investors in 2008 here:
Permanent Portfolio in Iceland
Also there is an interesting book from FerFal that details what happened in his home country of Argentina. I reviewed it here and it contains some very interesting first-hand accounts of what happens when a currency does a swan dive:
Surviving the Economic Collapse
I’m not a doom and gloomer, but I do think that all portfolios should have some protection in place for sudden currency problems. It is often way too late to respond once the markets for a currency begin to go sour. You need protection in place well before and you must hold it at all times no matter what the market sentiment may be. This is why the 25% gold allocation in the Permanent Portfolio is so critical to have at all times in the allocation.
H/T to Lew Rockwell’s Mises Institute for this.
Have Gold ETFs Ruined Gold as an Asset Class?
1 year ago
Forum member “murphy_p_t” posted an article from the Wall Street Journal:
Behind Gold’s New Glister: Miners’ Big Bet on a Fund
From the article:
…skeptics argue GLD could become a Godzilla-like beast if the gold rally reverses sharply. They say its buying has already turbo-charged gold prices, exposing the market, and legions of small investors, to a rapid fall. Smaller copycat funds add to the risk.
“We tell our clients to watch out for it, because it’s there, and it’s a real risk,” said Jeffrey Christian, founder of CPM Group, which advises major investors worldwide on gold…
This is a fair question. Have gold ETFs ruined the gold market? I don’t think so.
Gold ETFs were actually around when Harry Browne was still alive so their use in the Permanent Portfolio was considered. They are not the preferred way to hold gold in the Permanent Portfolio however.
But to the question. Yes, gold is more accessible now but it’s not likely to impact the results because people are still buying it for the same reasons they did when it was less accessible: protection against possible inflation.
I think blaming a gold ETF for the rise in gold prices is a bit of a stretch. It completely ignores the market reactions to overseas and domestic spending (welfare and warfare) which has historically been inflationary. It also ignores the unprecedented actions of the Fed after the housing bust to dump dollars into the falling market. This is not saying inflation is coming because there are good arguments for deflation. It’s just saying that the market’s reaction and jittery nature with buying gold is not totally unjustified given the past few years of market turmoil, banking failures, government spending, etc. This is hardly the fault of the Gold ETFs and I suspect gold prices would have gone up anyway even without an ETF around based on these incidents.
But this is an issue brought up by Rick Ferri in the Podcast I had with him. He made the same point about gold ETFs. My point is why doesn’t this apply to value stock investing strategies? Or how about just the stock market in general? The emergence of cheap stock index funds and ETFs has not ruined the markets has it?
If the gold prices plunge it’s not going to be because of a gold ETF. It’s going to be because the markets think that money is better invested somewhere else (stocks, bonds, T-bills, etc.). The gold ETF will be the poster boy for the fallout, but blaming it doesn’t make much sense. Even before the ETF existed gold purchases were routinely done by large institutional players and indivuduals. So gold trading is not a new phenomena for the markets and they carried on through ups and downs just fine.
But does a gold ETF impact the portfolio ideas and diversification? I don’t think so. Buy, hold and rebalance the assets. I don’t worry about a gold ETF affecting gold prices any more than I do a stock ETF affecting stock prices. Yes it made the asset more accessible, but that doesn’t mean the reasons people are buying it have changed.
If people want gold they want gold. If they want it in an ETF or a gold bar in safe deposit box it doesn’t matter any more than whether a stock investor wants a stock ETF or physical certificate in their filing cabinet. And ETF or no, the investors are going to buy that asset. In fact, these investment products exist and are popular because that’s what the markets wanted. Besides, gold has been popular in the past and in fact it had a much higher inflation adjusted price in the late 1970s/early 1980s (over $2200 in today’s dollars) when there was no gold ETF around at all. If ETFs are driving gold prices then how do we explain that?
Gold has always been a volatile asset. Same for stocks. Same for long term bonds. Nothing has changed. For a Permanent Portfolio investor it doesn’t matter anyway because we hold all the assets all the time and rebalance when needed. Gold prices in the portfolio have dropped almost 50% in the past with minimal impact on overall value. The following years the other assets more than made up for the losses. On the opposite side of the coin (pardon the pun), gold investors have been rewarded for holding the asset when stock investors have been severely beaten about the past decade. Every asset has its day in the sun and day in the dog house. This is why investors shouldn’t try to time the market and hold all the assets all the time no matter what they think may happen.
2010-11-04 – Asset Volatility and Risk
1 year ago
In this episode I discuss the four asset classes of the Permanent Portfolio and volatility. I also discuss risk in investing and the need to not look at assets in isolation in your portfolio.
Be sure to subscribe in iTunes to get podcasts automatically. Also be sure to rate the podcasts in the iTunes store:
http://itunes.apple.com/podcast/crawling-road-money-show/id400543437
RSS Feed:
Podcast: Play in new window | Download
Journal of Indexes: Rediscovering Gold As An Asset Class
1 year ago
Continuing on the last post, I was just made aware of an article from the Journal of Indexes outlining the usefulness of gold as a diversifying asset in an investment portfolio. It is a discussion of whether gold held long term in a portfolio is able to reduce risks and help returns. This paper says it can which is something that Harry Browne argued for some time and I also came to believe after doing my own analysis.
The main point is summed up in this quote:
In other words, an investor choosing to include gold in their portfolio allocation is likely to obtain similar returns at a lower level of risk than an investor who does not include it.
- Juan Carlos Artigas – Journal of Indexes
Their conclusion also encapsulates the thinking of why the Permanent Portfolio holds gold as part of the allocation:
Gold is first and foremost a consistent portfolio diversifier. Moreover, we find that gold effectively helps manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances. Such tail-risk events, while unlikely, can be seen to have a damaging effect on an investor’s capital. On one hand, short- and medium-term holders—individual and institutional alike—can take advantage of gold’s unique correlation to other assets to achieve better returns during times of turmoil. This is especially true given that gold’s correlation tends to change in a way that benefits investors who hold it within their portfolios. On the other hand, by including gold in their portfolios, long-term holders—such as retirement savings accounts, pension plans, endowments and other institutional investors—can manage risk without necessarily sacrificing much sought-after returns.
Our analysis suggests that even relatively small allocations to gold, ranging from 2 to 9 percent, can have a positive impact on the structure of a portfolio. We find that, on average, such allocations can reduce the VaR of a portfolio, while maintaining a similar return profile to equivalent portfolios that do not include gold. For the eight portfolios analyzed using data from January 1987 to July 2010, adding gold reduced the 1 and 2.5 percent VaR by between 0.1 and 18.5 percent.
We also note that investors who hold gold only in the form of a commodity index are likely to be under-allocated. There is a strong case for gold to be allocated as an asset class on its own merits. It is part commodity, part luxury consumption good and part financial asset, and as such, its price does not always behave like other asset classes and especially not other commodities.
Finally, while most of this analysis concentrates on risk in the form of tail-risk and volatility, gold has other unique risk-related attributes that make it very useful in periods of financial distress. For example, the gold market is highly liquid and many gold bullion investments have neither credit nor counterparty risk.
(emphasis added)
- Juan Carlos Artigas – Journal of Indexes
These and other points are made in my Gold FAQ as well. The bold parts I have hammered on repeatedly on this blog and on the Diehards forum. It was even made again in debates with Rick Ferri on the matter:
- Gold is a unique asset because it is a commodity but is also money.
- Gold can be held in a way with no counter-party risk.
- Gold moves for much different economic reasons than stocks and bonds and therefore can be a useful diversifier in bad markets.
- Including gold in a portfolio, even though it generates no interest or dividends, can reduce risk and increase returns because it does have capital appreciation under some economic conditions that are bad for stocks and bonds.
- Using gold along with stocks and bonds can insulate a portfolio against some severe market risks.
Again this discussion is separate from asset class pricing which is something we won’t know is “too high” or “too low” until well into the future. This discussion is about the merits of holding gold in a diversified portfolio along with stocks and bonds. I’ve long believed that holding some gold in a stock and bond portfolio is a good idea even if you don’t follow the Permanent Portfolio strategy. This article seems to agree with those findings as well.
DISCLOSURE: I see the author may be doing work for the World Gold Council. Although I agree with his conclusions, I just thought I’d disclose this fact to readers.
Gold Ownership in an Investment Portfolio
1 year ago
On some investment forums the idea of the Permanent Portfolio is very strange. After all, it holds gold and everybody knows that gold is a net zero real return asset (e.g. it matches inflation historically and that’s it). Or they say it’s in a “bubble” and it’s going to pop. Fair enough. But that still doesn’t mean an investor can’t use the asset intelligently in a balanced portfolio with stocks and bonds.
Speaking for myself I will say this: I don’t own gold in a portfolio because I want to. I own gold because I have to.
The reason I have to is because of the way modern central banking and paper currencies work. I am not hoping gold goes up in value because it represents a market outlook that is bad for the currency and performance of assets invested in that currency (like stocks and bonds). Yet I have to live in the world I have, not the world I want. In the world I have currency debasement is just part of what happens so I choose not to put 100% of my life savings in paper currencies. It would be great if stocks and bonds could go up forever without worry from sudden high inflation and other market problems. But that’s just not how things work in reality.
I don’t understand the controversy when an investor knowingly decides that they are willing to put 25% of their wealth in an asset that historically (as critics point out) has largely been impervious to monetary shenanigans. Critics will go on about needing to devote 100% of their wealth to “growth” assets but history, indeed even recent history, has shown that sometimes these assets like stocks and bonds can do especially bad for extended periods. Not only do we have the 2000s as a recent example, but the decade of the 1970s had very bad inflation which was not good for the markets then either.
So an investor decides to look at the history of the markets and reasons that the “stocks and bonds are all you need” mantra falls flat under some economic conditions. This is not exactly breaking news to anyone that has spent any kind of time looking at the data. The reality is that a stock and bond portfolio alone has had dismal returns for decade+ periods and holding some kind of hard asset in a portfolio was not a bad idea during these times. Theory or not, these are just the facts.
A common criticism is that a portfolio that holds stocks, bonds, cash and gold shouldn’t work because of the assets it holds. Yet if you look at the data, including empirical data, it does work. Not only has it managed to weather some terrible storms in the market with very low draw down, but it has posted gains that may not be barn burners but are OK for people that are looking for moderate returns and lower risk.
Even if gold were to drop to $0 tomorrow morning it would represent a loss of -25% to the portfolio as that wedge became worthless. Barring the very unlikely nature of this happening, compare it to the -40% losses that stock investors took in 2008. Even a “balanced” stock and bond portfolio took a -25-30% loss that year. Yet somehow those kind of losses are acceptable to critics because it’s a “growth” asset. That’s not the kind of “growth” I want.
Therefore holding gold in a portfolio is not a big deal if you are rebalancing it and holding it in combination with stocks, bonds and cash. It doesn’t matter if one of the assets is in a “bubble” because investors will be rebalancing out of it into the laggards. Damage is limited by the design of the allocation and the assets it holds.
The reason the Permanent Portfolio holds four assets in 25% allocations is to work as a firewall against serious damage during market swings. Even if one asset does especially bad one year with, say, a 50% drop that would be a -12.5% loss to the portfolio. This is not great, but also not a life destroying event. That also assumes that no other asset in the portfolio rises by another amount to offset the losses.
The data on the portfolio is extensive and, most importantly, empirically tested. It is not theory. Basically the complaints about it amount to this: “It can’t work because my theories say it shouldn’t!”
Fine. But if the empirical data is showing one conclusion and the theories say another outcome should happen then what does that mean? Is the empirical data wrong or the theories?
