Podcast - 2011-04-03 - Cash and the Permanent Portfolio

[craigr]

Podcast for April 3rd, 2011

Topics

Cash for the Permanent Portfolio

What kind of cash to hold
What kind of cash not to hold
Why cash is important in the Permanent Portfolio

Reader questions

Why not use aggressive stock funds for the portfolio?

Can I rebalance early to prevent from panicking in the portfolio?

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[Lone Wolf]

I've finished all but the last 9 minutes of the podcast and wanted to drop a few comments.

First, good arguments on the power of cash.  The taxation argument is not one that Browne emphasized a ton, but it's a good addition to the usual arguments for cash's role in recession (to scoop up higher interest rates and be able to load up on cheaper assets until the recession passes.)

Since it sounds like you use them pretty extensively, I was hoping to hear more of your thoughts on Treasury Money Market Funds, particularly about their rarity and their generally high expense ratios.  I was scratching my head about this in another thread.  Most of these funds appear to hit you with around 50 basis points of expenses.  I simply can't understand why this is so and certainly can't justify it.

I also would have liked to hear your thoughts on the various ways that one can purchase individual Treasury Bills and Notes.  I build a 0-3 year Treasury ladder in my Fidelity account but I didn't hear you really mention much about individual purchases, either through a brokerage or TreasuryDirect.  I find it fairly easy to do and it doesn't come with any expenses (depending on the brokerage you use.)  Do you like approaches like this or do you see any potential problems?

I was glad to hear you (and your questioner) mention Browne's "Best-Laid Plans" book!  I strongly concur that this is a great purchase.  I believe that I picked mine up for about $2 from a used books vendor on Amazon.  Although lots of the material is dated, the beginning half should permanently inoculate you against trusting some guru to ever predict the financial future for you.  I know that I'll never view someone's assurances that something "has to happen" the same way after reading it.

By the way, I'm sure you noticed that there were a few audio issues at the beginning of the podcast.  It sounded a bit muffled.  I know very little about audio so I am sure there is a term for this.

Thanks as always for these great podcasts.

[Pkg Man]

By the way, I'm sure you noticed that there were a few audio issues at the beginning of the podcast.  It sounded a bit muffled.  I know very little about audio so I am sure there is a term for this.

I think the audio issues just make the show seem that much more like the original.  Craigr, perhaps you should record at least one podcast by dialing in over a land-line from Arizona 

All jesting aside, I agree with Lone Wolf.  Thanks for taking the time and effort to produce them.

[craigr]

Audio issues.

Yep. I don't have my pop filter and this is affecting things. The audio quality will improve once I get it out of storage again. I am still playing with things like auto level control, etc. My boom is also in storage so I have to set the mic up on books and this makes judging my mouth/mic space harder. With the boom I can have more consistent audio. This be will resolved in the next month or so once I finish my move.

Treasury Funds

Vanguard's funds are cheap but currently closed to new investors. A cheap option is to use the iShares SHV (very short treasury) ETF. There are more transaction fees, but the expense ratio is 0.15%. With interest rates so low it may make even more sense to split the funds between Treasury MMF and the ST Treasury funds as I laid out. Totally optional though.

I have not done individual Treasury Bills. I just don't find I need to do it with the Treasury MMF and ST Treasury funds I use. But I suppose it could be done at Treasury Direct or perhaps even some brokers very easily as you point out. I've just never tried it.

[moda0306]

Craig,

Did I understand you right that you think I-bonds should be sold every year?  I'm curious to hear your logic.  If one were to have purchased a 3% + inflation I-Bond from 2000, why on earth would they have wanted to ever sell that?

That thing would have been kind of a super-cash, carrying a high fixed rate guaranteed for 30 years but with none one could sell it at face value if rates skyrocketed.

[Lone Wolf]

Did I understand you right that you think I-bonds should be sold every year?  I'm curious to hear your logic.  If one were to have purchased a 3% + inflation I-Bond from 2000, why on earth would they have wanted to ever sell that?

I might have heard incorrectly, but TIPS and I-bonds were both being discussed under the inflation-indexing umbrella.  My brain interpreted that part as referring to TIPS, basically meaning, "If you use any TIPS in your cash allocation, make sure you are using very short-term TIPS.  Hold them to maturity.  This is kind of weird for cash but should work fine as long as you don't get too crazy with it."

I very well could have heard incorrectly though.

[moda0306]

I loved the podcast, but was a little disappointed that i-bonds didn't get a louder/longer shout out.  Their flexibility (as long as you've got some cash you can have bogged down for 1 year), tax deferral, and higher historical interest are impressive.

[craigr]

Ibonds and TIPS are different products and I shouldn't lump them exactly together. I don't use either but have considered using ibonds for some of my cash. I mention them because others have liked them. If I was holding a TIPS fund for my cash I would try to make it as short as possible. But honestly if you are keeping your duration very short the inflation protection of TIPS is basically worthless but the tax deferral of I bonds may be worth having.

Again I mention them as a possibility for people, but I don't use them myself. Which is another way of saying that they may be fine, but I've not done enough research to truly understand all the risks under various economic climates.

[KevinW]

Good podcast, but again I'm scratching my head at the common suggestion on this forum that value stocks are the path to higher beta.  In other places it's commonly accepted that value stocks are generally mature companies that pay dividends, and both factors tend to make their price less volatile.  Growth companies generally pay no dividend and are priced based on projections of future expansion, which tend to make them more volatile.  If anything I would think a PPer might replace the total market index with a growth index.  Indeed, PRPFX picks growth stocks.

For my part, I'm a TSM believer.

[MediumTex]

Good podcast, but again I'm scratching my head at the common suggestion on this forum that value stocks are the path to higher beta.

I wasn't aware that was a common suggestion.

Every time I see this idea I try to talk people out of it when it comes to the stock portion of the PP.

Did craig get into this topic on the cash podcast?  I haven't listened to it yet.

[KevinW]

Well, there have been a fair number of references to value tilting, including a brief mention in the Q&A section of that podcast, and I can't recall anyone ever asking about growth tilting.  Maybe "suggestion" was the wrong word and I should've said "inquiry."  Anyway conventional wisdom seems to say that if you want more beta, look at growth stocks.  As I said I believe the total market is the way to go, but I'm curious why value has more mindshare among people interested in the PP.

[MediumTex]

Anyway conventional wisdom seems to say that if you want more beta, look at growth stocks.  As I said I believe the total market is the way to go, but I'm curious why value has more mindshare among people interested in the PP.

If I wanted more volatility I would certainly buy small cap stocks (preferably those that are about to go up! ).


I'm with you, though, on just going TSM for PP purposes.

[craigr]

Good podcast, but again I'm scratching my head at the common suggestion on this forum that value stocks are the path to higher beta.  In other places it's commonly accepted that value stocks are generally mature companies that pay dividends, and both factors tend to make their price less volatile.  Growth companies generally pay no dividend and are priced based on projections of future expansion, which tend to make them more volatile.  If anything I would think a PPer might replace the total market index with a growth index.  Indeed, PRPFX picks growth stocks.

For my part, I'm a TSM believer.

Great follow-up, Kevin.

Ok first of all it is no secret that I am a TSM guy and is what I said over and over again. But people sometimes want to try to squeeze some more performance out of the portfolio and value investing is usually the first place to look. Now Browne did talk about "aggressive" stocks, but this is a really nebulous term. Same with "Growth". They are nebulous because they require a manager often to make these calls. What is one person's "Growth" stock is another's "Sell it because it's gone too high" stock.

But counter-intuitively the best place for volatility is not growth usually, but value stock funds. This is because they often are filled with companies that have been the most beaten down in price. So, the idea goes, that they are more likely to benefit from a good recovery because they have the furthest to go back up to hit the mean P/E and P/B ratios. Whereas growth stocks have been getting all the attention and the stock prices have been driven very high already by the time the fund notices them to put more money in. This is usually not a good investment play.

In fact, if you look at the three IShares Russell 3000 index funds (blend, value and growth) you see that the value funds tend to have slightly more Beta and more volatility as shown in standard deviation:

http://finance.yahoo.com/q/rk?s=IWV+Risk
http://finance.yahoo.com/q/rk?s=IWW+Risk
http://finance.yahoo.com/q/rk?s=IWZ+Risk

iShares Blend Beta: 1.03
iShares Value Beta: 1.07
iShares Growth Beta: 1.00

And std. deviation

iShares Blend std. deviation: 18.41
iShares Value std. deviation: 19.16
iShares Growth std. deviation: 18.36

Even in small cap you see a slight edge to the Value:

http://finance.yahoo.com/q/rk?s=IJR+Risk
http://finance.yahoo.com/q/rk?s=IJS+Risk
http://finance.yahoo.com/q/rk?s=IJT+Risk

iShares S&P 600 Small Cap Blend Beta: 1.16
iShares S&P 600 Small Cap Value Beta: 1.20
iShares S&P 600 Small Cap Growth Beta: 1.13

iShares S&P 600 Small Cap Blend std. deviation: 22.33
iShares S&P 600 Small Cap Value std. deviation: 23.07
iShares S&P 600 Small Cap Growth std. deviation: 21.85


So in the above you can see a slight edge to the value funds for Beta and Std. Deviation which means they tend to be more volatile than the market in general. But again look at the differences in these funds. It's negligible. Now these funds have been around less than 10 years, but you get the idea that it's not a slam dunk as many may believe. When you wrap in the turnover costs and generally higher expenses involved with the value funds the differences become very blurry in terms of performance.

Now we could argue that a tilt to small value is best. And some people do this. But I prefer to optimize for my taxes and market efficient portfolio so it's not something I do. BUT if you really want to do it, then just use a good index fund and don't tinker too much afterwards. Realize that you may have market tracking error and be prepared to wait it out. Most people won't be able to do this. IMO.

Lastly, Beta is a backwards looking measures. It can't tell you what the fund will do going forward. So building a portfolio on things like Beta (or Alpha) alone is not a good idea. One year Beta could be great, but then a bad streak hits and it can go against you.

The above is why I advocate the largest blend funds you can get and not to try to get tricky. The idea of picking more volatile stocks sounds great in theory, but in practice it's almost impossible to do consistently and the value premium may or may not pay for itself. It just depends on your timing.

Hope that explains my position a little better.

[Pkg Man]

I've gone back on forth on this one.  Initially I had some small cap, mid cap, international, and emerging markets.  Then I simplified to VTI and the S&P (VTI outside the 401k, S&P inside).  Then I decided (maybe performance chasing?) to add just a bit of the midcap fund to offset the large-cap overweighting from the S&P500.  It is only a relatively small amount, say 10% or so of the total stock allocation, and I can wait it out if it under-performs for a while. 

The way I see it, if I could buy VTI in the 401K for the same expense ratio as I can the midcap fund, then I'd just stick with VTI.  But I have ultra low expense ratio funds available in the 401K -- the S&P, Mid-cap, and Russel 2000.  Using the mid-cap and the S&P500 seems to be a closer way to replicate the return of the VTI.  But in the long run I doubt it will make much difference.

I don't see this as any different than others who have chosen to have a small allocation to foreign equities in their stock portion of the PP.

[craigr]

Now we could argue that a tilt to small value is best. And some people do this. But I prefer to optimize for my taxes and market efficient portfolio so it's not something I do. BUT if you really want to do it, then just use a good index fund and don't tinker too much afterwards. Realize that you may have market tracking error and be prepared to wait it out. Most people won't be able to do this. IMO.

Using yearly mean and standard deviation figures between 1926 and 2008 indicates that a blend of 50% small cap value and 50% T-Bills (correlation was -0.06) provided a similar annualised reward to that of 100% TSM.

I feel a deeper need to be more widely diversified. The US market has been remarkably smooth and profitable when you compare it to other countries over these same time periods. I'm not wishing ill-will on my countrymen, but we are the out-liar. Now it may go on for another 80 years just like it did the previous 80. But I'd want to keep the money spread around just in case it didn't repeat.

[AdamA]

A moving average cross-over is a form of stop loss style for example, being IN when the current price is above a moving average (200 day or 10 month moving average is quite a common measure) or OUT when the price is below the ma. Or you can use straight stop losses as-is, perhaps 5%, 7% or 10% below the purchase price for example.

This is a different investing/trading style than that used by the PP.  When you use a trend following strategy such as a moving average, you are buying after there is a slight rally hoping to catch the bulk of the trend as it continues.  PP would be considered a reversion to mean trading style b/c you sell assets as they rally and buy them as they fall.  

I'm not sure how it would be possible to use a moving average in the context of the PP.  I realize that you can trade the 4 asset classes using moving averages, but I don't think that this is really in spirit of the PP.  

[AdamA]

The impression of the PP spirit seems to me to be towards investing solely in the PP alone. For some that might be an appropriate choice. For many others it probably is not. I play devils advocate in order to provide a more balanced view that might provide potential investors with an insight into both the advantages and disadvantages.

I know you're playing Devil's advocate...

It seems like replacing the stock portion of the PP with SCV and T-bills is changing it in a very fundamental way.  I know that backtesting the numbers makes it look like a good option, but who knows what a given 20-30 year period will look like.  Like you say, some might be comfortable with this, but I think it will be hard for most to stomach at times when this combination is underperforming TSM.

I guess the moving average trading strategy is one way to go with VP money.  HB dedicated a few pages kinda bashing this idea in "Why the Best Laid Investing Plans..." 

I don't really get this idea of the PP being in a bubble.  The PP holds 4 asset classes.  Are you arguing that all four of these classes are in a bubble?

[Pkg Man]

I have no doubt that it is possible to earn higher returns outside the PP (my VP has outperformed the PP over the last several months), but I also believe my VP to be inherently more risky.  Whether or not trading systems or moving averages can be more profitable is not the important issue in my mind. 

If someone decides to fly planes into tall buildings again, the middle east explodes, a large bank fails, or any other unpredictable calamity strikes, I would feel much more financially protected with the PP than a stock-in portfolio no matter what the moving averages were doing.

IMHO, for most folks, those ideas about timing and beating the market are best left for the VP.

[MediumTex]

Clive's devil's advocacy reminds me of the investment equivalent of two of the three little pigs showing the third little pig some homebuilder's research demonstrating that stick and straw houses represent better home values than brick construction according to all conventional metrics.

The third little pig, I suspect, is similar to many PP investors and might respond by saying: "I understand what you are telling me, but what I am most interested in is Big Bad Wolf protection, and I'm not sure if sticks and straw will provide me with the wind resistance and quality of sleep I am looking for.  I don't mind paying a little more for the added protection, even if I may need it only infrequently."

[moda0306]

MT,

You never cease to amaze me.  Three Little Pigs?  Great point!

[clacy]

Clive, I appreciate your point of view and probably tend to agree with you quite a little.  I hold about 1/3 of my investable assets in the PP.  That is the portion of my assets that I feel is the most stable (but you can never be 100% sure about that obviously).  I also use some other strategies similar to Mebane Faber, where I do use 10 mo SMA as a filter.  I also use a relative strength technique as well, which ends up functioning similar to Faber's MA strategy, but with a wider range of sub-asset classes to chose from.

All said, I hope that the 3 different techniques provide a slightly higher return and lower volatility than any one strategy alone would.  As it stands, I'm using combining trend following with the mean reversion by using both methods, and I feel that both trend following and mean reversion each have their +'s and -'s.

I have tested timing the HBPP along with a MA filter and it does tend to smooth out volatility and enhance the return, however the data only goes back to 2003, so that isn't long enough to really get too worked up over.  If anyone has the ability to test the HBPP along with a MA filter such as the 10mo or 200 day, that dates back further, I would be very interested in that.

[MediumTex]

Clive's devil's advocacy reminds me of the investment equivalent of two of the three little pigs showing the third little pig some homebuilder's research demonstrating that stick and straw houses represent better home values than brick construction according to all conventional metrics.

The third little pig, I suspect, is similar to many PP investors and might respond by saying: "I understand what you are telling me, but what I am most interested in is Big Bad Wolf protection, and I'm not sure if sticks and straw will provide me with the wind resistance and quality of sleep I am looking for.  I don't mind paying a little more for the added protection, even if I may need it only infrequently."

If the sticks and straw house pigs have a Big Bad Wolf safe/panic room built-in then they might be as equally safe whilst enjoying a lower build cost. Whilst the third little pig is dragged down with years of heavy mortgage, pigs 1 and 2 might accumulate more wealth in having no mortgages. Every now and then when the big bad wolf comes along and blows down their houses, they have more than enough to carry the rebuild costs and still leave themselves better off than the 3rd pig.

What you are saying is true.

The problem is I am not always so rational when faced with the prospect of being eaten.  I might fail to make it to my piggy panic room before it was too late.  

The larger problem we are touching on here is that often the times that we most need clear rational thought is when it is hardest to think clearly and rationally.  I think that is probably why real investment returns are much harder to come by than backtesting and other research would suggest.  I think that most people are less risk averse than they imagine themselves to be, and they tend to find this out when they see 20-40% losses when the market periodically gets grouchy and they find themselves unable to think about anything except except cutting their losses.

[clacy]

Clive's devil's advocacy reminds me of the investment equivalent of two of the three little pigs showing the third little pig some homebuilder's research demonstrating that stick and straw houses represent better home values than brick construction according to all conventional metrics.

The third little pig, I suspect, is similar to many PP investors and might respond by saying: "I understand what you are telling me, but what I am most interested in is Big Bad Wolf protection, and I'm not sure if sticks and straw will provide me with the wind resistance and quality of sleep I am looking for.  I don't mind paying a little more for the added protection, even if I may need it only infrequently."

If the sticks and straw house pigs have a Big Bad Wolf safe/panic room built-in then they might be as equally safe whilst enjoying a lower build cost. Whilst the third little pig is dragged down with years of heavy mortgage, pigs 1 and 2 might accumulate more wealth in having no mortgages. Every now and then when the big bad wolf comes along and blows down their houses, they have more than enough to carry the rebuild costs and still leave themselves better off than the 3rd pig.

What you are saying is true.

The problem is I am not always so rational when faced with the prospect of being eaten.  I might fail to make it to my piggy panic room before it was too late.  

The larger problem we are touching on here is that often the times that we most need clear rational thought is when it is hardest to think clearly and rationally.  I think that is probably why real investment returns are much harder to come by than backtesting and other research would suggest.  I think that most people are less risk averse than they imagine themselves to be, and they tend to find this out when they see 20-40% losses when the market periodically gets grouchy and they find themselves unable to think about anything except except cutting their losses.

This is without a doubt, in my opinion, the greatest value in the PP.  It does seem to provide low volatility, which is something that the vast majority of investors could benefit from.  Most people simply aren't able to deal with large draw downs, which has been studied many times.  The fact is your average investor, tends to buy high and sell low.  The PP takes away most of the urge to do that, and actually re-balances at the opposite time that most investors would do on their own.  Clive, would argue that there are different ways to skin that cat however, and that the HBPP doesn't have exclusivity on providing low draw downs.

[KevinW]

Thanks craigr, Clive, and others for the detailed responses.

Stirring the pot a bit more: let's not consider assets in isolation.  Beta, as usually calculated, indicates volatility over the entire time frame, but in the PP we need stocks to be positively volatile during prosperity.  We can downplay volatility (or lack thereof) during other economic conditions.  We might measure this empirically by categorizing every year as prosperity-yes or prosperity-no, and calculating a beta over only the prosperity-yes years.  I can't work on this now but may play around with it when I get a chance.

Also, any discussion like this ought to reference Larry Swedroe's "minimize fat tails" portfolio.  FWIW I think Swedroe's portfolio will essentially work, but it makes two assumptions that make me uneasy: 1) the small-value premium will certainly manifest itself during your investing career, and 2) a stock/bond portfolio is adequately safe.

This is more devil-advocacy, though.  I agree that picking high-beta sectors is, like picking winning stocks, a form of future-forecasting, and future-forecasting is impossible to sustain.  The TSM is volatile enough to work, by definition "prosperity" must be reflected in the TSM, and the TSM is more convenient and economical than alternatives.

[craigr]

Also, any discussion like this ought to reference Larry Swedroe's "minimize fat tails" portfolio.  FWIW I think Swedroe's portfolio will essentially work, but it makes two assumptions that make me uneasy: 1) the small-value premium will certainly manifest itself during your investing career, and 2) a stock/bond portfolio is adequately safe.

I think Browne had the original minimize fat tails portfolio. My main grip with Swedroe's approach is that he has no hard asset exposure in that allocation. I think any portfolio with no hard asset exposure like gold is seriously vulnerable to bad inflation events.