The Permanent Portfolio: Reflections, Concerns, & Questions

[eDeslauriers]

I never commit to anything until I fully understand it, and this so happens to be one of Harry Browne’s “rules”? of wealth accumulation. Perhaps that is why I have traditionally been so hesitant about the whole idea of ‘investment’: I’ve never truly understood it, and because of that, I always felt deeply insecure about this whole paradigm of putting one’s entire life’s savings into a system that is so utterly volatile and mysterious. I’ve been exposed to the conventional “wisdom”? floating around the personal investment industry for a long time now, but I’ve never understood, really, what makes it all tick. And I never commit to anything until I fully understand it.

I was a university freshmen in September 2008. I vividly recall the atmosphere of those dark September days, and I always will. It wasn’t that long ago, but I feel, already, that people forget just how scared everyone was. There was a pervasive fear in the air, and it oozed out of the apocalyptic newspaper headings and the DEFCON5 CNN coverage. No one knew when, or even if, this thing was going to stop. I didn’t have so much as a penny in a savings account at the time, and I was still scared. I can only imagine if I had my life savings on the line how I would have reacted.

Was that the system I wanted to invest my hard earned capital in? Not really. But that’s just what people “do”?, right? Save 10% of your income; pay into a “growth”? mutual-fund because I’m young, 80% equity, 20% bonds. And then, magically, you’ll have money when you’re old. Or so goes the story.

In retrospect, it seems that the source of my investment-anxiety came from the fact that no one ever seemed able to explain to me exactly why this system or that system works. And I had a feeling like the authors of these different investment strategies or paradigms didn’t really understand the mechanics either. 80% equity and 20% bond? Why? “Because in the past 85 years it has annualized with a 9 or 10.something% return, in the long run, so just buy-and-hold that and you’ll be golden by 65! [and no mention of volatility or risk]”? Well, “in the long run”? the sun rises in the morning and sets at night, but that isn’t an explanation, it’s just an observation. I wanted to invest in something that I understood.

The problem with most of the conventional investment models out there is that they make some pretty substantial assumptions which they accept on faith. And if those assumptions don’t pan out, many of these portfolios risk significant, even fatal damage.

There had to be an alternative. So I started digging. If my education taught me anything, it is how to be an effective, analytical researcher. And that’s probably why, once I decided to really learn about the fundamentals of investment, that I eventually stumbled upon the Permanent Portfilio. Immediately, it caught my eye, like a glinting diamond in a dungy pawn shop.

Reflections

I will not explore the details of the Permanent Portfolio. If you are reading this, you probably are well aware of what makes the PP “tick”?, and why it is an investment vehicles which outperforms, on a risk-adjusted basis, 99% of the conventional vehicles the average person invests in.

I will say this, however: I have relentlessly tried to “hack”? the PP. For the past month I have experimented with dozens of different allocations percentages, I’ve changed out sectors, exposed the portfolio to this, that, and the other, I’ve twisted, contorted, and pretzeled the PP into every conceivable manifestation… yet I have not found a single variation of the traditional PP which radically outperforms on a risk-adjusted basis without making substantial assumptions and bets on the future which I do not truly understand. Indeed, I have beaten the PP many, many times with various Frankenstein versions. But you never quite know what you’re going to get when you experiment with things that you don’t totally understand. You might even create a monster.

For this reason, I advice this: don’t fuck with the PP.

Concerns

After much (much!) research, deliberation, backtesting, brainstorming, and lots of coffee to stimulate all this activity, I have decided to entrust my life’s savings to the traditional PP. Unlike most people, who just throw their money into a mutual-fund, or (if they are “ambitious”?) an equity/bond blend of their own design, I can say that I actually understand how my investment vehicles works…for the most part.

I do have some concerns. Many of my initial concerns with the PP have long ago been washed away through some combination of research or back testing. A few stubbornly remain, however – and they all are related to deep risk.
One of the biggest appeals of the PP is its low short-term volatility as well as its long-term protection against systemic risks. It is the PP’s hedging against both forms of risks which fundamentally makes it an attractive portfolio.
However, I cannot help but feel that there are several deep-risks that the PP does not take into consideration. This is a problem, because if there are fundamental risks which the PP is exposed to which it does not account for, and therefore potentially does not hedge against, then the entire appeal of the PP vanishes.

Questions

I consider this the final stage of my research into the PP. These are the questions which nagging remain. I bring them to this community for I have no found answers to them anywhere else. I therefore present them in the form of direct questions.

Is the PP over-exposed to fiat currency?
Does the 50% allocation in fiat currency (through the LT gov. bond/treasury allocations) represent a significant risk to the PP in the event of a currency crisis? I do not have long-term faith in strength of fiat currency for the simple reason that history informs me that I shouldn’t. The Fiat Story always ends the same way. And it isn’t pretty.

Considering this, does the PP make the unreasonable assumption that the US dollar (i.e. any fiat currency in the world) will always exist? Yes, the gold allocation of the portfolio hedges against inflationary risk that is inherent in a fiat system. But is the gold allocation enough to hedge against the implosion of literally half of my portfolio?

With 50% direct exposure to the $, I fear that the PP would be devastated if (when) the $ collapses. Sure, maybe it won’t happen for a hundred years, and by then I’ll be dead. But that is making a substantial assumption, a gamble, a risk that is perhaps not properly accounted for and hedged against for by the PP.

And let’s be honest here: with a world-wide debt crisis coming to a slow boil, is anyone really convinced in the long-term viability of fiat currency? Or are they all just taking it on faith that the dollar is valuable?

Thoughts?

Is the PP “Peak Oil”? proof?
Peak Oil, or more accurately, “Peak Efficient Energy”? is one of my favourite pet-subjects because it is the closest you’ll get to a being able to gaze into an economic crystal ball.

Demand for energy continues to rise (and will to rise and has to rise, as long as the world monetary system is driven by debt). But that’s okay, because the supply of energy continues to rise in tandem! Infinite economic expansion for all! Huzzah!

Oh wait, right…energy is finite. Eventually the world will hit a tipping point. Demand will permanently outstrip supply. And that’s when infinite growth ends. That’s when the party’s over.

I could ask, “how will the PP react to an alien invasion”?, and then hedge against that risk by investing in tinfoil futures. But that isn’t a plausible scenario worth hedging against. ‘Peak oil’, however, isn’t only plausible, it is mathematically assured (barring the development of cold-fusion or some other self-sustaining energy supply). And I’m not going to be the fool and predict that “we will reach peak oil in March 2015!”? or some other none sense, but I will definitively predict that we will hit the peak oil wall at some point in my lifetime (I am in my twenties) and therefore it is a systematic risk which must  be hedged against.

How will the PP respond to the Peak Oil wall?

Thoughts?

Industrialized Equity or Emerging Markets?

By comparison to the previous two questions, this question is pretty straight-forward. Yet, I haven’t been able to figure this one out.

The way I look at it is this: there is way more room for long-term growth in developing economies, period. They were late to the industrial game, and therefore they present an opportunity for capturing the gains to be had from the incredible capital intensive process of industrialization. Those potential gains no longer exist in domestic markets because none of us were alive when domestic markets were going through this process. However, that potential still exists in emerging markets! It seems to me emerging markets are the place to be for long-term growth. But are there some systematic long-term risks that I am missing here?

Is it more profitable, on a deep-risk adjusted basis, to invest the equity portion of the portfolio in emerging markets?
Thoughts?

[Pointedstick]

Welcome to the forum. When it comes to investments, don't outsmart yourself and don't outthink yourself. I remember those days too (I graduated a year after you). It was all so very frightening. You're right to fear the fragility of the world financial system, but the truth is that the entirety of human civilization is built on houses of cards. Digital circuits that could be extinguished by a solar flare, fossil-fuel-based industrial agriculture, the imaginary value of fiat currencies, property rights originating from government theft of indigenous lands, you name it. My attitude is that worrying about this kind of stuff doesn't do much good. There isn't really anything you can do about it, and we're all going to die anyway. As it seems you've concluded, the PP is a pretty resilient investment portfolio that lets you experience some growth while staying safe in most non-world-destroying calamities without having to trade it all in for canned beans, rifles, and 1962 diesel trucks.

Yes, the US dollar will eventually lose the currency war the way the Mongols conquered China and the Roman Empire was destroyed by barbarian hordes. But of course… when? If you acknowledge that it could be in 100 years when you're dead then IMHO it falls under the category of "things now worth worrying too much about." If the timetable shifts up, you'll know it. Everyone with any financial intelligence will know it. You're not just going to wake up one day and discover that the vending machines no longer accept greenbacks and your credit cards have been cancelled.

Also, energy is not finite. Oil is, and natural gas is, but the quantity of energy available for human use is for all intents and purposes, infinite. At the very least, with our current level of technology, large parts of the world could convert to a 100% sustainable solar-and-wind infrastructure with thermal energy storage tanks, today. The cost would be huge, but it wouldn't look so bad if we run out of oil and gas, right? Don't worry too much about energy. We clever humans, with the aid of price signals and free enterprise, have a way of switching to the next best thing when something goes south, and we occasionally manage to invent something pretty clever too. Imagine how the world would change if we had 50% efficiency solar panels. I mean, just think about it! Impoverished countries in the Sahara could become fantastically wealthy practically overnight. And that's only 50%! My furnace is 90% efficient, and newer ones boast efficiency ratings of like 98.5%.

[mortalpawn]

Back in the 1970's the known world oil supply was going to be entirely exhausted by the year 2000. I remember that was the expert prediction.  Last time I checked it is 2014 and I can still get gasoline.  Why?  Because many of the "then-unacceptable" sources (tar sands, shale oil, etc) can now be used, and also we can drill underwater, and in places we never imagined and we've "found" more oil.  Will it last forever?  No, but as supply gets short, and oil gets more expensive, then other alternatives will suddenly be competitive.  Some of which we've not invented or even thought of yet.  Energy could certainly spike due to some disturbance in supply (like the 70's oil crisis) and over time prices will continue to rise, but I don't think it will suddenly be shut off at any point.

However, if oil prices do rise suddenly, it will certainly cause instant inflation (we also saw this in the 1970's) - since oil is used to manufacture and transport everything.  So yes - the PP does cover this case.

[Gosso]

How are you backtesting the PP?  Are you looking at only the US PP or the Canadian PP as well?

I have found the following site extremely helpful for backtesting and getting a better handle on the Canadian PP: http://www.ndir.com/cgi-bin/downside_adv.cgi

Regarding emerging economies, I agree there is more room for explosive growth there, but keep in mind that many companies based in developed countries are also highly involved with emerging economies.  According to this report for companies in the S&P 500 approximately 45% of all sales come from outside the US.

Regarding currency overexposure, I tend to agree with you, especially for a smallish country like Canada.  The way I look at it is the 50% in bonds acts as an anchor to the country you plan to live in for the foreseeable future.  For better or worse this provides a link to your country.  We can then play around with stocks a bit and expand the currency exposure to the USD, Euro, Yen, etc. by purchasing global unhedged stock ETF's.  The sweet spot seems to be 60% in your home currency, and then 40% in foreign currencies (ie 25% in gold, 15% in US/International/Emerging).  I'll let you play around with the backtester...it's great fun!

Having said that there is no reason why you couldn't just go with a simple 4x25% Canadian PP.  It is a bit bumpier, but provides roughly the same CAGR.  Do whatever helps you sleep the best.  As long as you stay within the general framework of the PP then it's hard to go wrong, IMHO.

[k9]

Imagine how the world would change if we had 50% efficiency solar panels. I mean, just think about it! Impoverished countries in the Sahara could become fantastically wealthy practically overnight. And that's only 50%! My furnace is 90% efficient, and newer ones boast efficiency ratings of like 98.5%.

That's very important, and I think this is something that is often overlooked. It looks like going from 90% (which is very good, almost perfect) to 98.5% is a small step : after all, it is only 8.5% better, it is just a little more "very good, almost perfect" ; but this is just a matter of perspective : very high percentages are common sense's enemy. When you look at it the other way, it means we went from 10% of waste to 1.5%. Look at that ! A 667 % progress ! Furnaces are now almost 7 times more efficient than a few years ago, when they were already very good !

With giant steps like that, it is hard to predict when the lack of fossile energy will be a real concern, actually. You are dealing with very hard to estimate probabilities, because things move very fast. We could live in a devastated world in 15 years as we could live in the most prosperous world ever known for the rest of your life. We don't know, we can't predict. Be prepared to live in the first world, as it really might happen, but don't bet too much on it.

[KevinW]

Good post. A couple comments;

I will say this, however: I have relentlessly tried to “hack”? the PP. For the past month I have experimented with dozens of different allocations percentages, I’ve changed out sectors, exposed the portfolio to this, that, and the other, I’ve twisted, contorted, and pretzeled the PP into every conceivable manifestation… yet I have not found a single variation of the traditional PP which radically outperforms on a risk-adjusted basis without making substantial assumptions and bets on the future which I do not truly understand. Indeed, I have beaten the PP many, many times with various Frankenstein versions. But you never quite know what you’re going to get when you experiment with things that you don’t totally understand. You might even create a monster.

I had this same experience. Backtesting a bunch of variations of the PP seems to show that all the variations work about as well, so you might as well take the simplest and most future-agnostic allocation of 4x25.

Is it more profitable, on a deep-risk adjusted basis, to invest the equity portion of the portfolio in emerging markets?

No, because you want all four assets to come from the same "economy," for whatever definition of economy you choose. You want all four assets to be orbiting the same planet, so to speak. If you hold US T-bills and US bonds then you should hold US stocks. If you hold Eurozone cash and Eurozone bonds then you should hold Eurozone stocks. I suppose you could create an emerging market PP but then the cash and long term bonds should come from emerging markets too. Although this sounds messy to implement.

2013 was an example of why this is; take a look at craigr's synopsis:
https://web.archive.org/web/20160324133 ... 3-results/
Gold and bonds went down, cash was flat, US stocks went up, but emerging market stocks went down. A US PP with EM stocks would've been down about 10.4% last year versus 2.4% with US stocks.

[Kshartle]

When I look at Emerging markets vs. the US I look at VWO vs. VTI.

P/E on VWO vs. VTI is 11ish vs. 17ish.

so earnings in the emerging markets are 30% less expensive or to put it another way the earnings yield in the US is only 5.9% vs. 9.1% in the emerging markets.

There's no way to know if the US will continue to outperform, whether on the upside or the downside. We do know that based on objective measures the Emerging markets are much cheaper.

The dividend yield on VWO is about 60% higher than on VTI also.

For some historical perspective, at the height in 2007, VWO was 76% of the price of VTI. VWO would have to go up about 85% tomorrow to be back at that ratio.

At the bottom of 2008 after EM had been slaughtered, VWO was 50% of the price of VTI. That was the absolute crushing low of EM, which bottomed out before the US market. VWO would have to go up about 25% tomorrow just to be back at that ratio.

There is no way to predict the short term. If you have a long time horizon as I do....you shouldn't be scared out of buying EM at this price. It might fall further but by every objective measure I can see it is vastly cheaper than the US market. I like to buy stocks when they look cheaper. I think in the long-run (5+ years) that's a better strategy.

I pretty much only bought gold mining stocks last year. We'll see if that works out. I'm only buying EM this year...starting with my 2014 Roth IRA contributions in the next couple weeks.

[Kshartle]

When I look at Emerging markets vs. the US I look at VWO vs. VTI................................


I pretty much only bought gold mining stocks last year. We'll see if that works out. I'm only buying EM this year...starting with my 2014 Roth IRA contributions in the next couple weeks.

Since I posted this VWO has returned 13.2% vs. 5.8% for VTI.

I think there's a definate advantage for buying whatever is currently percieved as on the verge of a crash and EM was being characterized that way back in Jan.

I don't know how to model something like that though. There is probably a sentiment indicator that polls "dumb money"* to see what it's thinking is risky. Anyone know of any? When everyone was freaking out about Russia in late March I bought, and didn't even get the absolute low. Up 11% on that nibble, we'll see what happens.



*Assumes I'm not a part of so-called "dumb money"

[Pointedstick]

I think there's a definate advantage for buying whatever is currently percieved as on the verge of a crash and EM was being characterized that way back in Jan.

I don't know how to model something like that though. There is probably a sentiment indicator that polls "dumb money"* to see what it's thinking is risky. Anyone know of any?

Just watch CNBC!

[Kshartle]

I think there's a definate advantage for buying whatever is currently percieved as on the verge of a crash and EM was being characterized that way back in Jan.

I don't know how to model something like that though. There is probably a sentiment indicator that polls "dumb money"* to see what it's thinking is risky. Anyone know of any?

Just watch CNBC!

That's 50% of why I said EM was the stock index I would buy up and why I bought russia, along with the relatively very inexpensive valuations.

This still means I have to guage the sentiment through the filter of my ears and brain vs. looking at a metric that polls the sentiment of perpetual losers (people who buy high and sell low).

[Xan]

I think there's a definate advantage for buying whatever is currently percieved as on the verge of a crash and EM was being characterized that way back in Jan.

That sounds like the kind of strategy that might work (that is, return a small gain) 90% of the time, and then take you to the cleaners the other 10%.  In other words, not worth the risk/reward.

[Kshartle]

I think there's a definate advantage for buying whatever is currently percieved as on the verge of a crash and EM was being characterized that way back in Jan.

That sounds like the kind of strategy that might work (that is, return a small gain) 90% of the time, and then take you to the cleaners the other 10%.  In other words, not worth the risk/reward.

I'm not advocating putting all your money in it.

I'm also not talking about buying one company or something that can go to zero. An index or industry isn't going to go to zero. I'm talking about buying whatever everyone is saying is super risky and has either crashed or everyone expects a crash. That implies risk priced in or over-priced.

When the worst-case scenario doesn't occur the resulting move is likely to be large not small as the shorts have to cover. That means 9 large gains for every wipeout. I'll take those odds on any investment. The key is identifying the point of total capitulation by the weak hands.

[Xan]

Doesn't that describe the situation with long bonds right now?  Are you buying long bonds?

[Kshartle]

Doesn't that describe the situation with long bonds right now?  Are you buying long bonds?

No that's the opposite. People and to a larger extent institutions that don't care about price have loaded up on long bonds. It's viewed as risk-free because the principle and interest payments will be made regardless of the economy, the ideas that the fed can prevent rates from going up if they so choose and inflation is unlikely.

They are near all-time historical highs so this would be the exact opposite of what I'm talking about.

Now shorting them here would be going against the grain but I'm not a fan of shorting anything except the dollar itself by purchasing gold/stocks.

[MachineGhost]

I don't know how to model something like that though. There is probably a sentiment indicator that polls "dumb money"* to see what it's thinking is risky. Anyone know of any? When everyone was freaking out about Russia in late March I bought, and didn't even get the absolute low. Up 11% on that nibble, we'll see what happens.

60% drawdown rule.  Works on countries, sectors, industries, but not individual stocks.

[Kshartle]

I don't know how to model something like that though. There is probably a sentiment indicator that polls "dumb money"* to see what it's thinking is risky. Anyone know of any? When everyone was freaking out about Russia in late March I bought, and didn't even get the absolute low. Up 11% on that nibble, we'll see what happens.

60% drawdown rule.  Works on countries, sectors, industries, but not individual stocks.

What is that MG, just buy whatever has dropped 60% or start watching it at that point looking for signs of reversal?

I think that's a good number. Silver is down 60% plus from it's all time high and I am looking at it although I have virtually no cash at the moment having dropped 10k into the miners on Friday.

Maybe in 2 months I'll buy a couple hundred ounces if it's still lingering under $20.

[MachineGhost]

What is that MG, just buy whatever has dropped 60% or start watching it at that point looking for signs of reversal?

Start watching it for a bottom after it goes past 60% drawdown.  Scratch top-level sectors.  They don't have enough narrowness to drop 60%.  Works best on countries and maybe industries.

[Kshartle]

What is that MG, just buy whatever has dropped 60% or start watching it at that point looking for signs of reversal?

Start watching it for a bottom after it goes past 60% drawdown.  Scratch top-level sectors.  They don't have enough narrowness to drop 60%.  Works best on countries and maybe industries.

This is the approach I take with my investing which is all long-term and is not trading.