Is the 'Permanent Portfolio' Permanently Broken?

12/23/13 

By Roger Nusbaum

NEW YORK (TheStreet) -- During the depths of the bear market that followed the financial crisis, some investors desperately sought alternatives to the typical equity portfolio. 

One solution, which dates back to the 1980s, is called the "permanent portfolio." In its purest form, this means allocating equal 25% portions to equities (via a broad-based index fund), gold, long-dated bonds and cash. The portfolio is re-balanced once a year. 

The basic premise is that one of the four asset classes will always perform well. 

The argument tied to the Fed is on very weak ground as gold peaked 27 months ago while the Fed has continued to buy Treasuries hand over fist. The correlation argument is alive and well as gold has had an almost perfect negative correlation to equities this year. For now there is not much of a fundamental catalyst for gold to go up, so the permanent portfolio would appear to have 25% allocated to something that is relying on hope to go up. Of course,  hope is not an investment strategy. 

The biggest obstacle for the future of the permanent portfolio in its purest form would be an end to the 31-year bull market in bonds as proclaimed by Barron's over the weekend. People have been able to borrow money essentially for free, but that can't last forever. If Barron's is right and the bull market ended last May, then the permanent portfolio would appear to have 25% allocated to something that can't go up. 

DYI Comments: Dear Roger in your article for the Permanent Portfolio Strategy to work all you need is one asset class to be a winner and the rest can be losers.  Historically it has been one winner with a second asset in a supporting role.  If long term bonds have dismal performance it will not affect your overall return unless you are trying to out guess the markets.  

For those of you who are not familiar with the Permanent Portfolio Solution as devised by the late Harry Browne click over to my page for other links explaining this investment idea.

Roger's article does call attention to the problem(s) of the Permanent Portfolio when one or more of the four assets are not performing especially if it is in a secular bear market.  However the whole point that Harry was making that an investor would not have to make any economic or financial decisions regarding the future direction of gold or security prices, relieving average Joe/Jane the burden of out guessing markets.  As we know most folks will end up buying high and selling low to such a degree they feel the markets are rigged.  By following Harry's advice to re-balance when "any of the four investments has become worth less than 15%, or more than 35%, of the portfolio's overall value.(Fail Safe Investing [Harry Browne] page 47)."  This creates a very low portfolio turnover investment strategy that DYI would recommend.  How well has this investment strategy performed??  From 1972 to 2012 the average annual rate of return is 9.6% this is a dead heat as compared to 100% invested in stocks BUT with significantly lower volatility!
  
The above chart is from Craig Rowland's Crawling Road a web site I highly recommend.

Here at DYI I recommend using the Permanent Portfolio Fund (PRPFX); the re-balancing is done for you.  Notice gold from its peak in the early eighties only to go on a 20 year bear market OR when stocks went on a rampage starting in 1993 till 2000.  Would average Joe/Jane have the fortitude to re-balance into gold (or gold mining shares) for a 20 year secular bear market?  Or throw caution to the wind and go "ALL IN" with stocks during the 90's go go years?  Greed and Fear.  Average Joe/Jane trips them up.  Use PRPFX and let them do the heavy lifting.  Please note that PRPFX fund has additional assets but they are uncorrelated, the same effect with low volatility and similar returns as Harry's four assets.

For those of you who crave absolute simplicity of  a one fund approach that is broad based with uncorrelated assets to achieve similar long term(10yr plus) return as stocks but with very low volatility then use exclusively PRPFX.

What I've done is added a Variable Portfolio to add a bit of spice to the returns without going "ALL IN" and abandoning permanent portfolio strategy.  I've shown here as a 50% / 50% approach you can dial down to a lower percentage such as 75% PRPFX / 25% Variable etc.  I don't recommend going below 50% for PRPFX as that would nullify the basic premise of the strategy.  

HELPING HARRY

12-1-14

50% Permanent Portfolio Fund

(PRPFX)

1/2 Positions of our Aggressive Portfolio (No Short Funds)

Variable Portfolio 

42% - Cash -Short Term Bond Index - VBIRX

  8% -Gold- Precious Metals & Mining - VGPMX

  0% -Lt. Bonds- Long Term Bond Index - VBLTX

  0% -Stocks- Total Stock Market Index - VTSAX
  0%-REIT's- REIT Index Fund - VGSLX

[See Disclaimer]

Harry Browne (deceased), the investment manager who came up with the Permanent Portfolio solution to deal with all market conditions at all times.  His basic idea is to have 25% of one's portfolio in Cash, Stocks, Gold, and Long Term Bonds. These are uncorrelated assets at it's best.  By re-balancing the portfolio the total value moves up slowly with very little draw downs (temporary losses).

However the biggest complaint is primary with the gold and stock enthusiasts' who are advocating at any one time having more or less in gold or stocks. There are times when the gold bugs or stock maniacs will be correct in having an increased position. I've simply cut in half our Aggressive Portfolio excluded any short position.  Currently the bugs, maniacs, bond mavens or real estate moguls are not happy.  The Federal Reserve with their sub atomic low interest rates has pushed the market for these assets to nose bleed levels; returns going forward will be dismal at best.

DYI 

Consider a No-Drama Bond Market

This thirty-year period has been a golden period for bonds. For sure, part of that period coincided with a strong bull market in equities, especially in the United States from the early 1980s until March of 2000. But since then, equities have been both volatile and flat, while bonds have continued their relentless bull-march, with yields falling and prices rising. 

If technological innovation and the emergence of the global middle class continue, companies exposed to those phenomena will continue to reap disproportionate rewards, as they have been for well over a decade. That, in turn, would explain the strange yet undeniable strength in equities—at least as credibly as the thesis that equity markets are up and bond yields are down only because of central bank machinations. 

So, in short, by all means prepare for the end of the bond bull market. It is probably done. By all means consider the possibility of a bear market in bonds and turmoil in equities. It would seem that most of us are doing just that. But we should also be prepared not for the trend to reverse but rather for it simply to stop, with stocks a beneficiary, as they most certainly have been, with or without the help of central banks.

DYI Comment:  Most likely is for the U.S. to have very low inflation/modest deflation for the next 4 to 5 years until the Boomer's begin to retire in mass causing a labor shortage and budget busting entitlement costs pushing up the rate of inflation in the 2020's.  Until then it is very possible
interest rates will stay low, however the capital gains possibility for bonds is most likely finished or very muted simply due to the low rates.
DYI