Permanent Portfolio:How to Invest If You Have No Idea About the Future
If you ever read or watched the financial news, you’ll encounter a myriad of pundits expressing their views on where the economy and markets are heading in the future. Many of them are contradictory and even denounce others who hold completely opposite views. A majority of these pundits have top of the line pedigrees like PhDs in Economics from Ivy League schools and/or years of managing successful hedge funds. Underneath all of the carefully constructed arguments and rebuttals lies a fundamental truth: there is only ONE future and they can’t all possibly be right, no matter how much prestige and past success they command!
Well, I got good news for you: you don’t need to know much about what the future holds in order to invest effectively on your own! Some of you, especially those with an elite education, will proclaim that the answer is easy: if you don’t know what the future holds, then just keep your net worth in cash! Well, it might not that bad of an idea if inflation never existed which hasn’t been the case for many millenia so far. So the next obvious choice is to deposit your cash into savings accounts and even CDs which offer modest amounts of interest, but unfortunately, these have had a very poor track record of keeping up with inflation, especially after the taxes on the interest have been subtracted. What about inflation-protected bonds like TIPS? Ironically, even though they’re designed to keep up with inflation, you’re virtually guaranteed to always receive a return less than the rate of inflation, after taxes and commissions are collected!
I know what you’re thinking now: So how the hell am I supposed to invest?
Harry Browne (1933-2006), an investment analyst and the American Libertarian Party’s presidential candidate in 1996 and 2000, devised a simplified model for the economy by asking 2 questions:
- Is Economic growth High or Low?
- Is Inflation High or Low?
Under each scenario, one particular asset class will perform better than the others:
- Stocks: High Economic Growth
- Cash: Low Economic Growth
- Gold: High Inflation
- Long-Term Government Treasuries: Low Inflation
Under the premise that the future is unknown, the resulting portfolio is an equal-weighted mix of the above 4 asset classes known as the Permanent Portfolio. An overly simplified analogy of this strategy is like to going to the racetrack and betting on all of the horses.
Implementations of the Permanent Portfolio
Disclaimer: This section is NOT a solicitation to buy any investments but just an overview of the menu of options for implementing the Permanent Portfolio.
Disclosure: I’m Long PERM, Long SPY, Long IAU, and Long TLT as of this writing in May 2015.
Pacific Heights Asset Management has managed the PRPFX mutual fund since 1982, which somewhat follows the Permanent Portfolio philosophy. Be warned that it uses active management and generally allocates over 30% to stocks, more than the 25% recommended by Harry Browne. While it’s a good choice during long bull markets, it’s likely to result in moderately severe losses in market crashes like 2008, although not as severe as a portfolio full invested in the S&P500.
Global X Funds managed the Permanent Portfolio ETF (ticker: PERM) since 2012. It’s a low cost choice for the beginner investor but the relative lack of trading volume makes it impractical for high net worth portfolios.
There are many different implementations but I’ll go over the simplest one:
- Invest 25% of your portfolio in SPY (the S&P 500 ETF)
- Invest 25% of your portfolio in a Gold ETF fund (GLD or IAU)
- Invest 25% of your portfolio in a Long-Term Government Bond Fund, e.g. TLT.
- Keep the remaining 25% in cash if your broker pays decent interest. Otherwise, pick a short-term Government Bond fund as a proxy (e.g. SHY.)
- Important: Whenever any asset deviates more than 10% from the target 25% weight, rebalance back to the target weights. You can also rebalance via contributions as an alternative.
Strengths of the Permanent Portfolio
- Less drama (volatility): Look at the charts of any of the Permanent Portfolio index funds above and compare it to the S&P500 and you’ll easily notice that the movements are far less dramatic. Depending on your implementation, you would have lost maybe 1-2% or even came out with a gain in 2008 while most equity-heavy portfolios were completely decimated.
- The money has to go somewhere: Whenever the stock market crashes, stocks are being sold at record volumes and money is being pulled out. That money doesn’t just disappear; it HAS to go somewhere, whether in another asset class or in people’s bank accounts. Sophisticated investors, who constitute the vast majority of the trading volume, know that cash and savings accounts are not ideal long-term investments so they’re constantly looking for a different asset class to park that money in. Thinly traded asset classes, be it agriculture, timber, or baseball cards are not ideal, at least not on a large scale. Real estate, while the largest asset class in the world by total market value, is relatively time consuming to buy and sell whereas stocks, bonds, and commodity futures can be traded with a click of a mouse. By owning other major asset classes: government bonds, cash, and gold, it’s likely one of your assets will be in demand when another is going to the doghouse so your portfolio is much less likely to crater.
- Simplicity/Minimalism: 4 equal-weighted assets, what more could you ask for?
Weaknesses of the Permanent Portfolio
- Long-term returns are slightly below the S&P500: If you harbor an extreme set and forget mentality, then this strategy might not be for you. Just buy an S&P500 fund, contribute to it regularly, and look at the millions of dollars you ended up with 30-40 years later. For the rest of us who like to check performance on a regular basis, a slight hit to our performance is a worthwhile tradeoff for a substantial improvement in stability.
- Doesn’t always correspond to the bull/bear market cycles: If you have the strange habit of comparing your portfolio performance with your friends for bragging rights, then this portfolio isn’t for you. Get used to seeing it return +/- 0.3% or so on the days the S&P500 gains more than 1%. Also, it actually lost about 3% in 2013 when the S&P500 gained about 30%.
- Only proven to work in a fiat-money society: 1/4 of the portfolio is invested in gold which doesn’t result in significant inflation-adjusted returns over the long run. Note that gold was illegal to own between the Great Depression and the early 1970s in the US so there’s only about a 40 year track record for this portfolio.
Since there are countless ways of calculating returns and utilizing rebalancing rules, I’ve never run into any two articles, documents, blog posts, etc. on the Permanent Portfolio proclaiming the exact same set of yearly returns (unless they were carbon copies of each other.) So I’ll direct you to the Crawling Road blog:
You can also backtest the performance on ETF Replay by entering the following ETFs in 25% weights: SPY, GLD, TLT, and SHY and choosing a rebalancing scheme.
Although I’ve given a basic overview of the Permanent Portfolio, it by no means constitutes as specific investment advice (even though I personally invest a large portion of my liquid net worth in this strategy as of this writing.) You are urged to do further research before committing to any investment strategy. I recommend starting with Harry Browne’s book Fail-Safe Investing and the more modern Permanent Portfolio book by Craig Rowland and Mike Lawson. For the latest news on the Permanent Portfolio, definitely follow and subscribe to the Crawling Road blog which is also run by Rowland. In future posts, I’ll guide you through how to modify and expand on this strategy for a more personalized portfolio.