The Permanent Portfolio, Investing, Finance and Random Thoughts.
Posts tagged risk management
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.
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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?
