After 2008 many people swore off stocks. “Too Risky!” they say and then tell you about their hot new investment in a multi-level marketing scheme or their Uncle’s new franchise opportunity. Isn’t it funny how whatever assets you don’t own you always think are “too risky” when someone else owns them? I’m as guilty as the next guy on this. For instance, I don’t touch junk bonds and emerging market debt. It’s too risky. But I think I can make a better case for this position than people who don’t own any stocks for the same reason.

I own stocks and I admit it. I feel comfortable with stocks in my portfolio because they represent an ownership stake in the productive capacity of my country. Every time someone buys a Coca Cola, a computer or any other product they hand me money through the profits. When I’m awake they are handing me money. When I’m asleep they are handing me money. They are handing me this money 24 hours a day and seven days a week across the planet as they make their purchases.

Stocks have risks. Sometimes these risks show up in big price declines. But sometimes these risks cause the prices to climb far higher and faster than any other asset you can own. Over time, stock dividends reinvested can grow capital by large amounts through compounding. This makes it different than assets like gold which cannot grow on its own as it pays no dividends.

While market risks can impact a company’s stock over a period of time, I also realize that most companies are resilient and can adapt to changing economic conditions and survive. Not all of them can do this, but most do. This is why I own a broadly based stock index fund. Such a fund may own over 5,000 individual company stocks. This means any one of company going bankrupt has an insignificant impact on the entire portfolio. Not only this, but stock index funds are cheap. Every penny an investor saves in management fees is another penny in their pocket each year to compound and grow.

I know the markets have proven to be efficient over time. This means it’s almost impossible to outperform the market averages as everyone else on the planet receives the same information you do almost instantly. I recognize that sometimes the markets are not 100% efficient all the time. But I also recognize that it’s close enough that debating the point is academic because rebalancing between assets eliminates these risks.

I admit that all the brokerage houses receive news of major events within seconds and have computers and people that will trade positions just as fast in reaction to it. Therefore, I don’t try to compete with these people by out trading them because someone like me is always the last to know. Instead, I just hold on to my boring index fund that owns everything and profit from the thrashing the professional and amateur traders are doing underneath. Over time, my index fund will beat in excess of 95% of all of them.

The markets are random. The price movements are not predictable day-to-day or even each year so I balance my stock ownership with assets like bonds, gold and cash. I don’t own just stocks because owning 100% in stocks is extremely risky and not guaranteed to bring any more success than a diversified portfolio. I know there have been protracted decade-plus stretches where stocks have performed poorly in real terms (such as the 1970s and 2000s). Therefore, I reject the idea that stocks are the only asset any investor needs. Instead, I diversify just in case the next decade of under-performance happens to be during a period of time when it could hurt me.

I understand that portfolios which do not have any stock exposure face the risk that they will not be able to grow faster than inflation over time. So I accept that stocks have risks of loss in order to ensure I have the chance to take advantage of gains when they present themselves to grow my money. Although assets like gold and bonds by themselves are useful to diversify against certain market risks, I know they may not be enough to beat inflation and grow the portfolio alone. That’s why I own stocks.

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:

The Permanent Portfolio allocation is 25% stocks, 25% bonds, 25% gold and 25% cash. In this series of posts we’re going to talk about how to implement each one of these components to take advantage of the economic cycles of Prosperity, Inflation, Recession and Deflation.

This FAQ is divided into two sections: Short Answers and Long Expanded Answers. If you don’t want to know the details then just read the Short section and skip the Long Expanded section. This page will be updated from time to time as more common questions and answers are needed.

We begin this series with discussing the 25% stock allocation and Prosperity.

Short Answers

Why own stocks for Prosperity?

Stocks are the #1 asset to have during times of prosperity. During these times the economy is sound and growing. Inflation is under control (less than 5% per annum) and not causing any rapidly rising prices. Market interest rates will be stable and perhaps slightly falling. People are happy.

In prosperity it is not uncommon to see stock prices rise sharply as companies grow, expand and produce profits for investors. Annual stock returns (price increase + dividends) could be in the +-10% historic range. Times are good, employment is stable, people are spending money on products and services. Stocks are going to perform well.

What kind of stocks should I own in the Permanent Portfolio?

You should own a broad-based stock index fund that captures the maximum returns offered by the stock market without trying to beat the market with speculative stock bets.

That means you want to use a stock index fund and only a stock index fund.

Why is an index fund the best choice for the Permanent Portfolio?

Because index funds are the average of the entire stock market. It represents the average returns an investor could expect that year without trying to beat the market. Over time it has been shown that index funds will beat almost all actively managed funds.

What stock index fund should I use?

There are many index funds available today. Some are good, some are mediocre and some are downright bad. You want to own the cheapest and most broadly-based stock fund available. That leaves two main choices:

1. Standard & Poors (S&P) 500 Index
2. Total Stock Market Index

No you can’t. You don’t want a fund manager making decisions to move between stocks, bonds, cash, commodities, etc. and disturbing the strategy. You must use a fund that is 100% invested in stocks at all times for the stock portion of the portfolio. The Permanent Portfolio holds assets that will protect you from big stock losses already. You don’t need a manager trying to out-guess the markets.

This rule is not flexible. Do not break it.

What about owning International stocks and what index should I use?

International exposure is not so important to US investors. The US Economy and companies are already all over the world. There is also currency risk with international stock investing which can hurt performance in some cases. However, if you wanted to own some international exposure then perhaps 5% or so of the portfolio is fine (so 20% US index and 5% Intl. Index).

Again the international index should be cheap and broad-based. The EAFE international index, FTSE international ex-US index or what is sometimes called a Total International Index are good choices:

iShares EAFE Index (Ticker: EFA)

Vanguard FTSE ex-US Index (Ticker: VEU / Mutual Fund: VFWIX)

Vanguard Total International Index (Ticker: VGTSX)

Fidelity Spartan International Index Fund (Ticker: FSIIX)

Harry Browne did not openly advocate international diversification in the Permanent Portfolio, but his associates have said a little is OK.  Also, some international index funds charge slightly more because of the added expense of trading on foreign stock exchanges. Therefore, international stock index funds are more expensive but should not exceed 0.75% in expense ratio.

What’s the recap?

1. Only buy index funds for the stock portion of the portfolio.
2. The index fund should be either Total Stock Market or the S&P 500.
3. The index fund expense ratio should be less than 0.50% a year (unless it is an international index and can be up to 0.75% a year).
4. Never purchase an actively traded stock fund unless you have absolutely no other choice available to you.
5. Do not try to beat the market with the funds. Your market protection is already built into the other asset classes you own. The stock asset class serves a specific purpose and you don’t want to tamper with it by trying to outguess the market.
6. If you want to own some international exposure you should limit it to about 5% allocation (5% Intl + 20% Domestic = 25% total in stock)

Long Expanded Answers

What is a stock index fund?

An index fund is a way of passively tracking a pre-defined basket of stocks. Index funds typically own several hundred to several thousand company stocks. These stocks are usually owned in proportion to the size of the company in the market. For instance an index fund owning the US Stock market will own a much larger number of shares of General Electric (a huge multi-national company) compared to small regional publicly traded company like a power utility.

The advantage of this approach is the index doesn’t need to engage in expensive activities associated with actively traded investment funds (such as research, analysts, advisors, etc.). Because the stock index fund owns the entire market it is expected to earn the average performance of the market in any one year minus their small management fees to maintain the fund.

What is the S&P 500 Index?

The S&P 500 is an index of stocks compiled by Standard and Poor’s that comprise the 500 largest and most liquid publicly traded companies in the United States by market capitalization. These are the companies you rely on every day of your life for just about everything you do. General Electric. Wal-Mart, 3M, Microsoft, Johnson and Johnson, Google, Coca-Cola, IBM, Home Depot, McDonald’s, etc.

You can see the entire current list here:

Current S&P 500 Companies

The S&P 500 represents around 70% of the total value of the US Stock market.

What is the Total Stock Market Index?

The Total Stock Market (TSM) index includes all the companies of the S&P 500, but also includes all the other publicly traded companies that aren’t quite big enough to make it into the largest 500 list. These are called “mid-cap” and “small-cap” companies which means they have a market capitalization (size) that is smaller than the biggest (which are called “large-cap”).

The TSM index is commonly called other names such as the Wilshire 5000 or Russell 3000. A TSM index commonly holds thousands of companies (3000-7000+) in the composition as opposed to the 500 of the S&P 500. The TSM index easily covers 98%+ of the entire US publicly traded stock market. This is why it’s called the “Total Stock Market” Index. It owns just about everything except tiny low-volume stocks or penny stocks.

Why should I only use index funds for the Permanent Portfolio?

Indexing is the best and most efficient way to invest in stocks. Not only does it guarantee you maximum possible returns because you own all the companies all the time, but it’s also cheap. A typical index fund may have an expense ratio of less than 0.20% per year. This means for every $10,000 you have invested in the index the fund management company is going to take just $20 for handling all the operations.

Compare this to a non-index fund which can charge 1%, 2% or more each year. It doesn’t sound like much, but for each $10,000 invested you’re paying $100, $200 or more every year to the managers. Over the years it starts to really add up and hurt performance. It’s like driving a car dragging an anchor behind it where the index is like driving that car dragging just an empty soda can.

Not only this, but most actively managed funds don’t beat the index fund over time. So you are paying more in management fees and you’re paying this extra cost for them to underperform the market. Yes, it’s true.

Didn’t Harry Browne recommend owning the S&P 500 Index in his book Fail-Safe Investing and radio show? Why use the Total Stock Market Index instead?

It doesn’t matter that much except maybe for taxable investors. The Vanguard S&P 500 index has been available for 30 years and was the world’s first commercially successful index fund. It has a stellar track record.

In the early 1990′s though the Total Stock Market came on the scene. It held a much larger number of stocks and should have slightly better tax efficiency. The overall performance between the two is largely identical depending from year to year. Over the past several years, companies like Vanguard (the pioneer in index funds and world’s largest fund company) are recommending to their customers to use the Total Stock Market fund over the S&P 500 fund.

The reason why I personally prefer the TSM over the S&P 500 is the wider diversification and tax friendliness.The S&P 500 index holds 500 stocks and sometimes when a company shrinks it is removed from the index and replaced with a new one. This can generate unnecessary selling for the fund and those costs are passed onto the fund holders. If  you are holding the fund in a taxable account this means you could incur capital gains taxes that you didn’t expect.

Because the TSM owns almost all publicly traded stocks at all times it tends to generate less capital gains vs. the S&P 500 because it isn’t required to sell a company when it gets too small and buy more of another when it gets too big. If a company gets too small in the TSM it is probably bankrupt and will be delisted. This is not a taxable event. Likewise if a company gets too big there is no need for the index to sell another company to make room for the new leader. The fund simply buys more of the new leader’s stock.

With the above said, we’re dancing on the head of a pin. Both types of index funds are quite tax-efficient and offer excellent performance. I simply prefer the TSM fund because I like the wider diversification and want to get any edge on tax efficiency I can. If you want to use the S&P 500 index, or have no other choice, then that is still an excellent decision and you will be in great shape for the Permanent Portfolio strategy. Don’t sweat it.

Shouldn’t I have a fund manager making stock decisions using their wisdom and insight?

NO! First of all the Permanent Portfolio has fixed allocation to stocks, bonds, cash and gold. You don’t want to own a fund for your stock portion and have that manager suddenly decide they don’t want to own stocks and go 100% cash or bonds. They can throw a real monkey wrench into the strategy if you have not only the markets moving around but now you have some fund manager trying to outguess what is going to happen next.

The Permanent Portfolio strategy has assets that will cover you if the markets are doing poorly or doing well. You don’t need a fund manager making decisions that could hurt performance.

But aren’t fund managers smarter than me at beating the market?

You aren’t trying to beat the market. Also, here’s a secret: Fund managers are the market.

Somewhere around 90% of all stock trades on the market are between institutional investors. That means mutual fund companies, pension plans, endowments, stock brokers, investment banks, etc. They are basically all trading against each other. Each has access to the same information, the same real-time news, the same hot tips, etc. Yet, one has decided to buy a stock and one has decided to sell that same stock.

What does this mean? It means they are both trading on virtually identical information and making decisions that are 180 degrees away from each other. How can that be? Simple: They are trading on random noise.

When you own the entire stock market you benefit from all the wisdom, research and money these other firms have spent analyzing the stocks of the companies in the index. The index holds all stocks. The stocks go up and down as earning outlooks adjust. You just sit back and collect the money without having to pay a bunch of MBAs to research everything and come to opposite conclusions about what to do. It’s the best deal going.

But can’t a good manager beat the market?

It’s no better than luck. Virtually every study performed on this area has shown it to be luck. It’s called the Random Walk because the market movements are equivalent to a drunk stumbling down the street. You can watch him and know he’s moving a particular direction, but at any moment he may change course, stumble, reverse or simply puke on your shoes. It’s not predictable and one of the core tenants of the Permanent Portfolio is not trying to predict the markets.

The important thing to remember is that each year the people who beat the market changes. One year you’ll have a hot fund manager and the next year they may rank near the bottom. Then a new winner will come up to beat the index only to find in a couple years they’ve faded away. And on and on.

Well as it turns out, over time as winners come and go the average annual return of the index funds just keeps climbing and climbing higher. After a decade or two the index fund owners find that their returns end up in the top quartile of performance without having to pay high fees to get it.

Think of it this way. Let’s say you’re a marathon runner in a group of 10 people. You’re not the fastest, but you have consistent performance and finish in the top half of all participants each time you race. Sometimes you’re 5th, sometimes 3rd, sometimes 4th, etc.

Now you enter a series of races against your nine competitors and you run each year for 20 years. Over that time the fastest runner the first year ends up dead last the next. The previous loser is now the winner. Then a new winner shows up and hurts his knee and drops out of racing entirely due to the injury. Etc. The years go by and you never win a race, but you’re consistent. You’re so consistent that you’ve racked up many 5th place, 4th place, 3rd place and maybe even a couple 2nd place finishes. You’ve never done really well each year, but you’ve also never done really badly. In fact you’ve managed to show up for each and every race and never missed one yet.

Well after 20 years of this consistent performance you will probably find that you’ve won the marathon series. Your rivals have either dropped out, burned out, or were never consistent enough to be in the top five. Your supposedly “average” performance pushed you into the well above average category because you are so consistent and reliable year in and year out.

That’s indexing. You’re not going to be the best each year, but over time you’re going to win. Promise.

What is a fair expense ratio for an index fund?

Anything 0.50% a year or below for a US index fund or 0.75% or below for an International fund.

Some companies offer S&P or Total Stock Market funds with outrageously high expense ratios of 1% or more. Do not use these funds unless you have no other choice available. If the index fund is charging more than 0.50% a year then you are being charged too much and need to find another option if you can.

Some international index funds charge slightly more because of the added expense of trading on foreign stock exchanges. Therefore, international stock index funds are more expensive but should not exceed 0.75% in expense ratio.

If your only choice is an expensive index fund or an expensive actively managed fund then choose the expensive index fund. The best choice though is a cheap index fund.

What is the difference between a Mutual Fund and an ETF?

An ETF is short for Exchange Traded Fund. This is a fund that can be traded intraday like any stock on the market. You can buy an ETF in the morning and sell it at lunch then buy it back again before you go home from work. This would be an incredibly bad idea, but you could do it if you wanted.

A typical mutual fund however allows redemptions and deposits on a fixed basis (usually at the end of the trading day). This means when you buy a fund you get the price of the fund after the market closes.  You can’t trade in and out of it multiple times a day. Some companies (like Vanguard) won’t even let you buy back into a fund you just sold until you wait 60 days. This is done to keep the market timers and performance chasers from hurting the long-term holders of the fund and keep down costs.

The difference here doesn’t matter much for a buy-and-hold investment strategy like the Permanent Portfolio. The hourly or even daily fluctuations in price are irrelevant. However there is one major difference between ETFs and Mutual funds: Trading Costs.

When you buy a mutual fund you send your money to the your broker or fund custodian and make the purchase. Many times if the mutual fund is with the same company there is no transaction fee for this. You would, for example, send your money into Vanguard and tell them “Buy as many shares of the Total Stock Market Index as my deposit allows.” They say “Ok.” The sale is made, and the shares deposited into your account with no other fees involved.

Well with an ETF you need to deal with a brokerage. You have to place a market order, perhaps worry about a bid/ask spread, then pay a commission on the whole transaction. The commissions at a discount broker can be less than $10 or be hundreds of dollars at a “full-service” brokerage for each trade.

The problem is if you are making many small trades then the ETF can get expensive. If you are, for instance, depositing $100 a month into your portfolio you may spend $10 just to purchase the ETF. In other words, 10% of your savings that month went into transaction costs! Not good.

However if you sent that same $100 into a mutual fund company they simply would buy into the fund and not charge you commission. So you save money on the upfront purchase. Much better.

Now there are times where ETFs make sense and I will recommend some ETFs later on. But the important thing to remember is you should do the transactions in bulk and not a bunch of small trades with ETFs. If you follow that rule you can avoid the small commission charges that can really add up over time.

What about using an index fund that tracks a specialty index like small-cap stocks?

This is not advised. You want the broadest based index fund that captures the widest returns available from the US Stock market. That means the S&P 500 or TSM funds.

But haven’t small-cap stocks beaten large-cap stocks over the years?

Academics say “yes”. Reality says “it depends”. There are periods of time when large-cap companies dominate the market returns and times when small-cap companies dominate the market returns. It is unpredictable.

Let’s look at a big stock bull market to make our point. From 1980-1999 Small Cap stocks returned 14.29% CAGR but Large Cap stocks returned 17.11% CAGR. So for nearly 20 years the supposed higher returns of small-cap stocks over large-cap stocks didn’t exist. That’s a long time to wait for a theory of small-cap outperformance to show up isn’t it? How many people would have been sticking with that idea by year 17 or 18 of the strategy? Not many.

A broad based index will ensure you can grab extra returns from any stock asset class because you’ll own all of them all the time.

And before you start thinking that you’d rather have 100% stock portfolio to get those great returns all I can say is “Good Luck!” That was a wild ride and one of the greatest bull markets in stocks in US history. Not only that, but there are periods on both sides of that date range (1970′s and 2000′s) when stock performance was horrible!

If you still need more information about why the small cap advantage may not be that big of an advantage after all, please see this speech by Vanguard Founder Jack Bogle:

The Telltale Chart

What about owning some international stocks?

Harry Browne didn’t advise this specifically. John Chandler, a close associate of Harry Browne and his former publisher says a little International exposure is OK but don’t go overboard.

My opinion is that 20% of your stock allocation percentage in International stocks is fine. That means 5% of your 25% allocation could be international stocks (5% – Intl and 20% Domestic).

The US is still about half the world’s economic output. It’s simply massive and not going away any time soon despite what some say. The fact is that American companies already have huge international presence and therefore international exposure already. Think about it and you’ll agree. General Electric has appliances, lightbulbs, generators, jet engines, etc. all over the world. You can’t hardly go anywhere on the planet without running into a McDonald’s or Starbucks. Microsoft and Apple Computer sell their products everywhere. Don’t forget food either. Archer Daniels Midland, Kraft, Campbells Soup, Coca-Cola, etc. export their products extensively. Caterpillar sells their construction equipment to everyone to build roads, bridges, buildings and everything else. Finally, you probably are flying on a Boeing plane to get to all of these places and rent a Ford or GM car to go to your Marriott hotel when you get there. Did you forget your running shoes for your morning jog? Not a problem. The store down the street probably sells Nikes.

Get my point?

So even if you think you have 0% international exposure by only owning American companies you actually don’t. It’s almost certain that the profits you receive from these stocks are generated from all over the world and not just from America.

What’s the recap?

1. Only buy index funds for the stock portion of the portfolio.
2. The index fund should be either Total Stock Market or the S&P 500.
3. The index fund expense ratio should be less than 0.50% a year (unless it is an international index and can be up to 0.75% a year).
4. Never purchase an actively traded stock fund unless you have absolutely no other choice available to you.
5. Do not try to beat the market with the funds. Your market protection is already built into the other asset classes you own. The stock asset class serves a specific purpose and you don’t want to tamper with it by trying to outguess the market.
6. If you want to own some international exposure you should limit it to about 5% allocation (5% Intl + 20% Domestic = 25% total in stock)

Let’s get to the meat of any investment strategy: How well does it actually work?

In a prior post we talked about the Permanent Portfolio allocation which is:

25% – Stocks (in a broad based stock index fund like the S&P 500)
25% – Long Term Treasury Bonds
25% – Gold Bullion
25% – Cash (in a Treasury Money Market Fund)

This allocation will provide protection when the economy shifts through the cycles of prosperity, inflation, deflation and recession.

Now, some may be thinking that this allocation sounds very different than what they’ve seen elsewhere. For instance, the idea of owning gold is scoffed at by some investment advisors because it has no dividends or interest. Long Term Bonds? Many will tell you that they’re too risky due to rising interest rates. How about Cash? Isn’t holding a bunch of cash missing out on the hot stock market action? And, only 25% in stocks? Well everyone knows that stocks always beat every other investment so surely you want more than 25%, right? Right!?

Not exactly.

The reality is the investment markets are uncertain and unpredictable. What may look good in a theoretical backtest may blow up horribly as economic conditions change. Even worse, portfolio strategies that should work well based history often don’t work in actual application as people abandon them due to volatility and long periods of underperformance. Finally, every reputable study on the subject has shown that relying on your gut instinct, hunches, investment gurus and hot tips to run a portfolio is a road to disaster for performance and safety.

The Permanent Portfolio strategy works because it has very wide and true diversification. You have exposure to assets that can grow your money safely at all times without having to predict the future. You also have protection in the diversification against losing large amounts of money which can cause you to abandon the strategy in bad markets.

A Couple Small Changes

I did make two small changes to the original Permanent Portfolio as investment vehicles have changed in type and availability over the years. Harry Browne recommended using the Treasury Money Market Fund for cash. I personally like using Short Term Treasuries in combination with a Treasury Money Market Fund which provides nearly identical risks but slightly better returns on your cash. Also, instead of using the S&P 500 Index, I’ve chosen to use the Total Stock Market Index(also called the Russell 3000, or Wilshire 5000 index). The Total Stock Market Index provides wider stock diversification (holds 3-7000 stocks) with slightly better results than the S&P 500 (which holds 500 stocks). The slightly better result is because the Total Stock Market also holds small and medium sized company stocks which can sometimes outperform the large company stocks of the S&P 500 alone. The Total Stock Market also has expected higher tax efficiency due to how the index is constructed and managed.

You can use my changes or not. It doesn’t matter much. If you stick to the S&P 500 and Treasury Money Market Fund as originally recommended the results are within about 0.50% (one half percent) annually (favoring short-term bonds and total stock market) through the years.

Historical Returns

Let’s look at the score card and see how the Permanent Portfolio Allocation has done the past 36 years from 1972-2008 (1972 is the furthest we have data for Gold which was taken off the fixed exchange rate in 1971).

The assumption in this table is we rebalance each year to get back to our 25% allocation split among all four asset classes. In the table below I’ve highlighted in Red the asset that did the worst in a particular year and Green for the asset that did the best. Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year. In the average column I highlighted in Orange any year with a loss for the portfolio.

Data pulled from the Simba Spreadsheet on the Diehards Forum. Gold returns pulled from: http://www.finfacts.ie/Private/curency/goldmarketprice.htm. NOTE: Gold prices were largely fixed before 1971 and tied to the dollar. So the prices of gold did not move according to market fluctuations much before 1971. 2008 values pulled directly from market indicators. LT Treasuries for 2008 reflects owning 25-30 year treasuries directly and not the market index 20 year benchmark (which the portfolio is not designed to use).

Results

The Compound Annual Growth Rate (CAGR) is 9.7% for the entire period.

The worse loss for the portfolio in any one year was 1981 which had you down only about 4%. The market problems through the decades were barely registered in the final return each year. This means the portfolio was able to provide these solid and stable returns with very low volatility and risk.

You’re probably wondering how this portfolio compares to other strategies. The Permanent Portfolio was able to rack up the following returns against these competitors if you invested $10,000 back in 1972:

Now, some might be thinking: “Hey, gold was price controlled before 1971 so it’s not fair using 1972 as the start because the price of gold shot up. It made it look better than it really was!” (OK, maybe you weren’t thinking that, but I was because it’s true and we need to consider its impact). We’ll start a couple years out in 1974 then, enough time that the gold market would have settled out:

The Permanent Portfolio allocation is always competitive with the 100% stock allocation and the 50/50 bond allocation. Anything within +-0.50% of each other is essentially market noise that can easily flip back and forth each year.

The most important part is the Permanent Portfolio never had wild gut wrenching swings in value. In 1973-1974 stocks lost 50% in value. In 1987, stocks dropped 25% in one day. During the 2000-2002 Internet bubble crash, stocks dove about 40% over two years and the NASDAQ dove 80%! In 2008 stocks were down about 40% for the year.

Yet given all the above the Permanent Portfolio was able to produce positive returns during these very bad markets. Most recently in 2008 we had the worst single year market crash since 1931 and the portfolio still squeezed out a 2% profit for the year. The Permanent Portfolio allowed you to avoid all those disasters but gave you performance on par with the far riskier 100% stock allocation.

Even better, the Permanent Portfolio was able to provide real after-inflation returns during some times when the stocks and bonds couldn’t (such as the decade of the 1970′s). This means that even though inflation may have been killing your stocks and bond returns (by giving you negative real growth even though they went up in value), the Permanent Portfolio was able to go above and beyond by several percentage points to give real results that weren’t being eroded by a falling dollar.

Take a look at the returns table above and notice how you’ll always have one asset class doing very well and one doing flat or badly. Isn’t that counter-intuitive that you should be able to profit from that type of movement? Nope. It’s diversification in action. The way the Permanent Portfolio uses its assets to diversify according to economic conditions is what makes it work so well.

We’ll talk more about this in the future.

Harry Browne and Terry Coxon formally introduced the Permanent Portfolio in their 1981 book entitled: Inflation Proofing Your Investments. Like most great ideas, the Permanent Portfolio was simple, but was not simplistic.

The Permanent Portfolio investment strategy is the first one I’ve seen that developed an allocation based on economic cycle analysis. The Permanent Portfolio idea separated these economic cycles into four basic categories:

1. Prosperity
2. Inflation
3. Deflation
4. Recession

At any one time the economy will be in one of these phases or transitioning from one phase to another. This is the secret of the strategy and why it works. The strategy does not attempt to predict when these things happen or guess how long they may last. Instead, it holds specifically chosen asset classes that respond well to these cycles no matter when they happen or for how long. 

By 1987, Harry Browne took the more complicated asset allocation presented in his and Coxon’s first book above and refined it to make it easier to implement. This version of the allocation was presented in his book Why The Best Laid Investment Plans Usually Go Wrong (Find a used copy if you can. Like all of Browne’s books, it’s a must read.). The allocation remained the same in all his investing books that followed. Here it is (Preferred investment vehicle in parentheses):

• 25% – Stocks (S&P 500 Stock Index Fund)
• 25% – Long Term Bonds (US Treasury 30 Year Bonds)
• 25% – Gold (Physical Gold Bullion)
• 25% – Cash (Treasury Money Market Fund)

These assets are always present in the portfolio in a balanced way no matter what is going on in the economy. Why were these assets chosen? Because they respond to the four economic cycles listed above:

• Stocks – During prosperity, stock Index funds capture the full market returns available.
• Long Term Bonds – During times of deflation, US Treasury long term bond prices will go up quickly in value. Bonds also do reasonably well during prosperity. 
• Gold – During bad inflation, gold bullion is the only asset that provides strong protection against a falling currency. 
• Cash – During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund acts as a buffer for losses while the markets adjust during these relatively short times of underperformance. It also does well during deflation. 

Remarkably, these four asset classes are all you need to handle good and bad markets. Again, it’s simple but not simplistic. 

Even better, this allocation provides safe growth of your money. This means you won’t have to worry about the crazy swings in the stock market that may cause large losses of your life savings.

In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike. 

What this means is the Permanent Portfolio strategy will move along through the years providing stable and secure growth. 

How stable and secure? We’ll talk about that in my next post. But I feel if you combine the Permanent Portfolio with the 16 Golden Rules of Financial Safety you will have a very solid investing foundation that will get you to your ultimate destination in one piece. 

In the meantime, if you haven’t purchased a copy of Fail-Safe Investing you should really consider doing so. This book explains the method to the strategy in a very easy to read and understand form. My postings here will clarify some common questions, provide you with insight into ways to implement the ideas, and delve deeper into the economic mechanisms that make the portfolio work. 

Harry Browne also discussed the Permanent Portfolio Allocation in this radio show link.

Fail-Safe Investing