The Permanent Portfolio, Investing, Finance and Random Thoughts.
Posts tagged risk management
Safe. Stable. Simple.
1 year ago
Safe. Stable. Simple. These are the words Harry Browne used to describe his investment philosophy in his October 10, 2004 radio show. He pretty much nails it.
October 10, 2004 Investing Radio Show
Safe
A portfolio that is safe is one that is invested conservatively but also with strong diversification in case things don’t go according to plan. People work hard for their life savings. Why gamble those savings on some get-rich-quick investing scheme that can cost a big chunk of it if things go wrong? A portfolio that is safe does not mean tucking the money under the mattress. What it means is that investors buy things only that they fully understand for a very specific reason. Risks are taken where they should be and avoided where they add nothing to the bottom line. A portfolio invested this way can hold assets that are “risky” but own them in a way where the risks wash out over the long run and produce actually safer and more consistent returns through diversification. Safety also means following some basic rules of investing that will make it much harder to fall into many common investment traps.
Stable
A portfolio that is stable allows an investor to not panic when the markets are in serious turmoil. Stability doesn’t mean investors won’t ever take a loss. What it means is that the losses will be dampened so that the pain is tolerable and not driving the investor to waking up in a cold sweat. These situations, if they occur, can cause investors to make bad decisions about their money usually at the worst possible time. Stability in a portfolio means that investors can focus on their work and savings which is really driving most portfolio returns (especially early on).
A portfolio that is stable also means it is giving out reasonable market returns. A consistent return over the years can grow a portfolio greatly due to compounding. There is no need to reach for the brass ring for double-digit growth because that always means higher risks. Higher risks means less stability and a potential for doing much worse in the markets than what an investor is expecting. On the other hand, a more consistent growth can prove incredibly powerful if just left alone and a stable portfolio means investors will leave it alone. Since long term investment success is related to the ability to stay the course and not try to time the markets, stability in the portfolio is an important ingredient because it helps keep emotions in check no matter what the markets are doing.
Simple
I love simplicity, especially for investing. Complicated investing strategies and products can conceal many risky moving parts underneath. Many times these risks will not be discovered until it’s too late. Not just this, but often financial advisors will sell complicated strategies because it makes sure you keep them around to manage it all for a hefty fee. Investing does not need to be, nor should it be, complicated. There is a strong relationship between complicated investment approaches, lower performance and higher risks – All things you don’t want. Portfolios that are simple have lower management fees, lower taxes, lower chances of hidden risks, and can be managed without the use of a financial advisor with very little time commitment on the part of the investor. All of these attributes ensure a greater chance of long-term investment success.
There you have it. Safe. Stable. Simple. The three words that define the Permanent Portfolio. If you’ve never heard this radio show, you’ll enjoy it. Harry Browne discusses these and other important topics that are the foundation for growing and protecting wealth.
Podcast: Play in new window | Download
Book Review – Books on Risk (and two podcasts)
2 years ago
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
2 years ago
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
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.
Too much gold hype…
If you want some no-nonsense ways to own Gold you can read my 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.
