Permanent Portfolio Shakedown part 2

[sophie]

Following the Part 1 article posted here a while back, this was an interesting and unusually sympathetic analysis of the Permanent Portfolio:

http://advisorperspectives.com/dshort/g ... Part-2.php

Cliff notes summary:  they note the remarkable performance of the PP relative to its volatility, and propose two adaptions that slightly improve returns while reducing drawdowns & volatility in backtesting.  One (tactical allocation using Mebane Faber's 10-month moving average strategy) we are already familiar with from Clive's posts.  The other is to apply volatility management, which they don't explain.  The two together increase the PP's performance numbers from 8.55% CAGR/Sharpe 1.25 (using quarterly rebalancing) to 9.61% CAGR/ Sharpe 1.75, which is quite impressive.

Anyone here know how volatility management works?  Just curious, though I'm a bit skeptical that any of us will manage to faithfully compute 10 month moving averages and volatility ratios on a monthly basis.

[Alanw]

Following the Part 1 article posted here a while back, this was an interesting and unusually sympathetic analysis of the Permanent Portfolio:

http://advisorperspectives.com/dshort/g ... Part-2.php

Cliff notes summary:  they note the remarkable performance of the PP relative to its volatility, and propose two adaptions that slightly improve returns while reducing drawdowns & volatility in backtesting.  One (tactical allocation using Mebane Faber's 10-month moving average strategy) we are already familiar with from Clive's posts.  The other is to apply volatility management, which they don't explain.  The two together increase the PP's performance numbers from 8.55% CAGR/Sharpe 1.25 (using quarterly rebalancing) to 9.61% CAGR/ Sharpe 1.75, which is quite impressive.

Anyone here know how volatility management works?  Just curious, though I'm a bit skeptical that any of us will manage to faithfully compute 10 month moving averages and volatility ratios on a monthly basis.

Sophie,
After reading the above article, I was about to reach a state of investment exhaustion similar to that which I experienced before finding the PP several years ago.  No doubt there are minor tweaks that might improve the PP's CAGR, volatility and drawdown.  But as HB stated in his books, the PP is designed for simplicity as well as returns and volatility.  In fact, he recommended reviewing the PP only once a year and rebalancing if necessary.  I have found this simplistic approach to be one of the great benefits of having a PP.  I'm not sure monitoring my PP for moving averages, volatility ratios, etc. would improve my well being and investment calmness that has taken a great deal of time to reach.

[craigr]

Following the Part 1 article posted here a while back, this was an interesting and unusually sympathetic analysis of the Permanent Portfolio:

http://advisorperspectives.com/dshort/g ... Part-2.php

Cliff notes summary:  they note the remarkable performance of the PP relative to its volatility, and propose two adaptions that slightly improve returns while reducing drawdowns & volatility in backtesting.  One (tactical allocation using Mebane Faber's 10-month moving average strategy) we are already familiar with from Clive's posts.  The other is to apply volatility management, which they don't explain.  The two together increase the PP's performance numbers from 8.55% CAGR/Sharpe 1.25 (using quarterly rebalancing) to 9.61% CAGR/ Sharpe 1.75, which is quite impressive.

Anyone here know how volatility management works?  Just curious, though I'm a bit skeptical that any of us will manage to faithfully compute 10 month moving averages and volatility ratios on a monthly basis.

Sophie,
After reading the above article, I was about to reach a state of investment exhaustion similar to that which I experienced before finding the PP several years ago.  No doubt there are minor tweaks that might improve the PP's CAGR, volatility and drawdown.  But as HB stated in his books, the PP is designed for simplicity as well as returns and volatility.  In fact, he recommended reviewing the PP only once a year and rebalancing if necessary.  I have found this simplistic approach to be one of the great benefits of having a PP.  I'm not sure monitoring my PP for moving averages, volatility ratios, etc. would improve my well being and investment calmness that has taken a great deal of time to reach.

Yep.

These strategies don't work in real life for individuals because you are constantly being presented with chances to second guess your decisions. Buy? Sell? Wait longer? People are not computers and emotions weigh heavy.

Even professionals have a hard time doing it. Prospectuses are filled with mea culpas of managers making wrong market decisions and costing investors money. Not to mention the much higher costs involved in doing these strategies which many backtests fail to account for.

[smurff]

But after establishing the permanent portfolio, if you're still interested in tactical asset allocation or volatility management, there's always the variable portfolio.

[MachineGhost]

Anyone here know how volatility management works?  Just curious, though I'm a bit skeptical that any of us will manage to faithfully compute 10 month moving averages and volatility ratios on a monthly basis.

It's a constant volatility strategy, where each quarter they add or subtract cash from the portfolio to increase or reduce the overall portfolio volatility back to the same average level as the original 25x4.  That's an interesting approach I haven't heard of before.  I will have to check it out.

Though the 10-month MA is quite simple in concept and to apply, once a month is almost an eternity.  If you're not involved with the markets every day to be reminded from the risk/stress, its liable to be a pretty hit or miss approach.  It requires strict long-term discipline to work long-term which humans are terrible at.  Algorithmitize it or forget it.

[Gosso]

But after establishing the permanent portfolio, if you're still interested in tactical asset allocation or volatility management, there's always the variable portfolio.

That's what I'm gonna do.  50% in B&H PP / 50% in actively managed (AM) PP.  In a way I treat the B&H as the cash, while the AM is designed to maximize return with the lowest possible volatility.  But I agree that AM will fail for most people simply because of emotions and second guessing.

It's a constant volatility strategy, where each quarter they add or subtract cash from the portfolio to increase or reduce the overall portfolio volatility back to the same average level as the original 25x4.  That's an interesting approach I haven't heard of before.  I will have to check it out.

I wonder if they're using past volatility or implied volatility?  And if they look at the volatility of each asset or the entire portfolio?  I'll have to see how this works with the SMA.

[MomTo2Boys]

Though the 10-month MA is quite simple in concept and to apply, once a month is almost an eternity.  If you're not involved with the markets every day to be reminded from the risk/stress, its liable to be a pretty hit or miss approach.  It requires strict long-term discipline to work long-term which humans are terrible at.  Algorithmitize it or forget it.

MG, I'm not familiar with how one would implement the 10 month moving average theory. Would you mind helping me understand what this would look like if someone wanted to use it? How would you go about it? What would you do, exactly?

[rickb]

Though the 10-month MA is quite simple in concept and to apply, once a month is almost an eternity.  If you're not involved with the markets every day to be reminded from the risk/stress, its liable to be a pretty hit or miss approach.  It requires strict long-term discipline to work long-term which humans are terrible at.  Algorithmitize it or forget it.

MG, I'm not familiar with how one would implement the 10 month moving average theory. Would you mind helping me understand what this would look like if someone wanted to use it? How would you go about it? What would you do, exactly?

This is detailed in Mebane Faber's book "The Ivy Portfolio".  Once a month (he suggests the last day of the month), update your 10 month moving average (for a PP version of this, you'd independently calculate MAs for each of VTI, GLD, and TLT).  If the current price on this day is more than the moving average, invest in this asset or stay invested.  If the current price on this day is less than the moving average, sell this asset (all of it) or stay in cash.  Buy/sell signals for the 5 Ivy portfolio assets are maintained at http://advisorperspectives.com/dshort/u ... erages.php .

Faber compares an always invested PP vs. a timed PP (and vs. his timed Ivy Portfolio) at http://www.mebanefaber.com/2010/10/28/t ... bernstein/

[MomTo2Boys]

Though the 10-month MA is quite simple in concept and to apply, once a month is almost an eternity.  If you're not involved with the markets every day to be reminded from the risk/stress, its liable to be a pretty hit or miss approach.  It requires strict long-term discipline to work long-term which humans are terrible at.  Algorithmitize it or forget it.

MG, I'm not familiar with how one would implement the 10 month moving average theory. Would you mind helping me understand what this would look like if someone wanted to use it? How would you go about it? What would you do, exactly?

This is detailed in Mebane Faber's book "The Ivy Portfolio".  Once a month (he suggests the last day of the month), update your 10 month moving average (for a PP version of this, you'd independently calculate MAs for each of VTI, GLD, and TLT).  If the current price on this day is more than the moving average, invest in this asset or stay invested.  If the current price on this day is less than the moving average, sell this asset (all of it) or stay in cash.  Buy/sell signals for the 5 Ivy portfolio assets are maintained at http://advisorperspectives.com/dshort/u ... erages.php .

Faber compares an always invested PP vs. a timed PP (and vs. his timed Ivy Portfolio) at http://www.mebanefaber.com/2010/10/28/t ... bernstein/

Thank you for helping me understand that.

If you do this, though, aren't you just begging the tax man for a serious walloping? Or am I missing something?

I'm so backward. Somehow I figured the theory was that if something was below the moving average, then you're supposed to buy more of it. Shows what I know.

[rickb]

If you do this, though, aren't you just begging the tax man for a serious walloping? Or am I missing something?

I'm so backward. Somehow I figured the theory was that if something was below the moving average, then you're supposed to buy more of it. Shows what I know.

Yes, this is a strategy that basically only works in tax deferred accounts.  The other issue is the psychology.  As the pot of money grows larger and larger, are you going to be willing to trade in and out your entire (say, gold) holding based on this signal?  For a while I seriously thought half PP and half IVY might make sense (over the last 30 years they show similar risk and return).  I've realized I probably couldn't follow through on the monthly signals and a buy/hold/rebalance strategy is much more tolerable (for me). 

Don't get me wrong - I think there's a lot to like about Ivy (or, even more of a thrill ride, Decision Moose).  But it definitely requires a tax deferred account, and it requires being able to stomach buying and selling large chunks of your portfolio based on the signals that are generated.  This approach is in some ways the polar opposite of the PP approach.  Instead of being based on a theory that there are 4 basic kinds of economic conditions it's based on a theory that people are lemmings (they'll follow the trend whether it makes sense or not).  Furthermore, PP never has you buying/selling large chunks of your portfolio.  From a diversification viewpoint, I think it probably makes sense to do both.  I, personally, just can't see myself blindly following the signals.

[MachineGhost]

I'm so backward. Somehow I figured the theory was that if something was below the moving average, then you're supposed to buy more of it. Shows what I know.

That does work, but only in the short term (<1 month) or the very long term (3-5 years).  In-between is where momentum works.

If you took out the surprise negative earnings announcements on growth stocks, there is no difference in returns between them and the market.

[gap]

Following the Part 1 article posted here a while back, this was an interesting and unusually sympathetic analysis of the Permanent Portfolio:

http://advisorperspectives.com/dshort/g ... Part-2.php

Anyone here know how volatility management works?  Just curious, though I'm a bit skeptical that any of us will manage to faithfully compute 10 month moving averages and volatility ratios on a monthly basis.

Sophie,

One way is to equalize volatility(risk). If you accept volatility as variance, a naive approach to this is by taking the inverse of the variance and normalizing it for you allocation. For example(%ages are purely hypothetical for ease of calculation) Let us say the variance of the the following assets are:
Bonds 20% Gold 33.333% stocks 25%. The inverse will be
Bonds 1/20%=5, Gold 3 and Stock 4. To normalize, i.e. the allocation %ages would be

Bonds = 5/(5+3+4)=5/12, Gold 3/12, Stocks 4/12

In practice:
a. it does pretty well and the allocations are close to PP allocations
b. the trouble is that variance is dynamic and it depends on what interval you choose and over what period
c. the naive approach does not take into account co-variance. To equalize risk taking this into account is a lot more math- but perhaps is not worth it because of all the uncertainties in the input above

[longeyes]

But since the inception of Faber's GTAA etf that fund is down about one per cent compared with +15 pct for PRPFX...