The Unreasonable Effectiveness of the Permanent Portfolio
The year is 1945, and you are a 25-year-old World War II
veteran looking to settle down and establish a family. Your parents lost
everything in the Great Depression, including their home.
Despite a three-year rally, the stock market has yet to
recover losses from the last 17 years. Friends and family were routinely
tricked by short-lived rallies over the 1930s, only to see their investments
decline yet again. You remember how the market lost over 50% in 1931 when you
were in middle school. Then, just when it seemed to be recovering; lost over
30% in 1937 during your junior year of high school. Why would 1945 finally be a
good time to invest in the stock market? No one you knew had done well by
investing in stocks.
The Silent Generation (1925-1945) maintained this aversion to
risk assets their entire lives. Succumbed to fear in the 1940s; missed out on a
once-in-a-generation secular boom in the 1950s with the Dow Jones rising 238.8%
over the course of the decade.
The year is 1981. U.S. Treasury Bonds purchased in 1977 lost
almost half their value in inflation-adjusted terms by 1981 Double-digit
inflation raged in a bear market that had started over a decade ago. Many
economists believed this stagflationary period of both high inflation and low
growth was an impossibility leaving many investors unprepared. How could this
have happened?
Sitting on the couch with your next-door neighbor admiring
Tom Selleck’s mustache on Magnum P.I., your neighbor brags about how they
couldn’t beat the “low” 10% mortgage rate they had if they ever sold their
home. Car commercial airs; advertising the new Ford Mustang with its auto-loan
at a “low, low 19% APR.”
At this time, the investor heavily concentrated in bonds
might have been laughed at. Yet, that is exactly what the most successful
investors did. As interest rates fell continuously over the next 30 years, the
value of their bonds increased dramatically.
Times do change. Human nature doesn’t. If past generations fared poorly by assuming that their direct experience represented a universal truth about how markets worked, why would it be any different for us?
We believe that nearly all investors alive today suffer from the same recency bias as those investors that preceded us.
To succeed as long-term investors, we
believe that we must be aware of our biases and truly take a long-term view across
many years, and many possible futures.
When we think about investing, we think about the course of an entire lifetime. How might we build an investment portfolio that can stand the test of time? One of our sources of inspiration for how to do this is Harry Browne and his Permanent Portfolio.
Harry Browne and the Birth of the Permanent Portfolio
Browne’s research divided economic history into four possible
macroeconomic regimes: Growth, Recession, Inflation, and Deflation. Browne
believed that any period of recorded economic history in any country in the
world could be fit into one (or a combination) of these four regimes.
Browne’s historical perspective from the 1980s was different
from ours. He had lived through a period of low growth and high inflation that
came to be known as stagflation – a combination of stagnant or slow economic
growth and high inflation.
Stocks tend to do well in periods of higher-than-expected
growth because companies are earning more money than expected which tends to
cause share prices to rise.
Bonds tend to do well in periods of lower-than-expected inflation
because their fixed-interest payments retain more purchasing power when the
inflation rate is stable or declining. The lower inflation regime often leads
to a decrease in interest rates, which can cause the price of existing bonds
with higher yields to rise, providing capital gains to bondholders.
On the flip side, a stagflationary period of
lower-than-expected growth and higher-than-expected inflation can be
challenging for stock and bond-focused portfolios. The high inflation means the
fixed interest payments from bonds can lag behind inflation and companies’ earnings
are sluggish.
Adjusting for inflation, the S&P Index peaked at 108.37
in 1968 and then fell 64% to 38.88 by 1982. The S&P didn’t return to its
inflation-adjusted 1968 level for 24 years. Bonds did poorly too over the
1970s, which had repeated bouts of high inflation. The real returns of $1,000
invested in a classic 60/40 stock/bond portfolio in 1968 were nearly zero for
two decades – finishing 1987 at $1,034.
The 60/40 Portfolio represents a 60% allocation to the
S&P 500 Index and a 40% allocation to IEF (with GFD extension). Returns are
inflation adjusted according to monthly US CPI.
In some ways, this period would be more challenging than
anything most investors alive today have lived through. The 2008 GFC and COVID
recessions were sharp but relatively short-lived. After bottoming in 2009, the
S&P 500 made new all-time highs in 2012 (nominal) and 2013 (real). The
COVID recovery was even quicker with the March 2020 lows being fully recovered
by the end of the year.
Imagine yourself 20 years older than you are today and what your life will be like. If you have kids, how old will your kids be? What will your career look like? What will your financial needs be?
Now imagine:
You
have less savings than you do today.
What does that imply about your life at that point? Are you
able to retire? Pay for your kid’s schooling? Give money to the people or
causes that you care about?
Browne lived through a period like this and it led him to
recognize the need for assets that could perform well in periods of low growth
or high inflation periods to help make up for where stock and bond-focused
portfolios struggled.
Looking at the tools he had available at the time, he came up
with a simple and elegant portfolio:
25% in Stocks which should do well in Growth
25% in Bonds which should do well in Deflation
25% in Cash which should do well in a Recession
25% in Gold which should do well in Inflation
By directly including assets that should do well in decline
and inflation periods like the stagflationary period the U.S. lived through, we
believe Browne made a large improvement to the traditional 60% stock/40% bond
portfolio. He called his alternative the Permanent Portfolio because it was
designed to handle each of these macroeconomic regimes.
Like the GI coming home after WWII that was afraid to invest
in stocks right before a major bull market, many investors seem to anchor to
recent history and expect that their experience is indicative.
However, the most recent ten or fifteen-year period is
usually not representative of the range of possibilities over an investing
lifetime.
Over the 54-year period from 1969 to 2023, about one
investing lifetime, we calculated growth and inflation regimes and combined
them to create four combined regimes:
Growth Up & Inflation Down
Growth Up & Inflation Up
Growth Down & Inflation Down
Growth Down & Inflation Up
What we see is that one sub-period can look very different
from what happened in another sub-period. Comparing the total period of
1969-2023 with two 14-year sub-periods (1969-1983 and 2010 to 2023), we see a
different mix of regimes.
2010 to 2023 was a period of low inflation with over 60% of
the period being categorized as low inflation. From 1969 to 1983, only about
25% of the period was marked with low inflation, leaving almost 75% as having
higher inflation.
One of the most common mistakes
investors make is to over-optimize their
portfolios for the recent regime.
The high inflation of 1969 to 1983 led to pretty lousy
performance by bonds. The investors in 1982 that referred to bonds as
‘certificates of confiscation’ were not unjustified in their feelings given bonds’
pretty lousy performance.
However, if they decided to remove bonds out of their portfolio, they likely regretted it. The next 40 years saw much lower inflation and better performance by bonds.
With apologies to Kurt Vonnegut, “[Financial] history is merely a list of surprises. […] It can only prepare us to be surprised yet again. Please write that down.”
The Permanent Portfolio
Resonates with us because it doesn’t try to predict the future.
It tries to be prepared by including assets
designed to perform in each of these macroeconomic regimes. The Permanent Portfolio approach was an important step in the right direction
from stock and bond-focused portfolios toward our objective of maximizing
long-term wealth while letting us be confident that we and our families will
have the financial resources to deal with what life throws at us.
The real magic though is not in just how the individual asset
selection covers different regimes, but how the combination of assets, the
overall portfolio construction, works.
Let’s take the three principal components of the Permanent
Portfolio: Stocks, Bonds, and Gold. Over the period from 1973 to 2022, stocks
and bonds were the best-returning assets and gold was the worst.
Based on this, you might think that “I want to get the best
long-term performance so I should invest in bonds and maybe some stocks.”
Well, what happens if we combine all three into an equally
weighted portfolio and rebalance it monthly?
The combination of the three does something pretty cool. It
performs better than the best-performing individual asset – stocks. At the same
time, its maximum drawdown is similar to its least risky and volatile asset –
bonds.
Stocks and bonds have the higher returns over this period.
Gold has the lowest return and highest drawdown of the three assets so it would
seem like adding it would decrease the overall performance. However, it
actually increased it!
The Permanent Portfolio:
Is greater than merely the sum of its parts.
Adding a lower-returning asset – gold – increased the overall
portfolio performance.
Because gold’s path was complementary – it performed well in
a couple of periods where one or both of the other assets struggled – it
improved the portfolio meaningfully.
This is the key lesson we take from the permanent portfolio:
Adding a lower-returning asset with a complementary (AKA uncorrelated) path can
improve the overall portfolio.
The inclusion of cash in the portfolio as Browne originally
proposed reduces the return (6.18%) but also reduces the volatility (6.95%) and
max drawdown (-15.09%).
On a risk-adjusted basis, the portfolio with cash is the best performer as it has a lower return but even lower volatility and drawdowns.
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