Improving on the Permanent Portfolio

[stone]

magneto, I think a corelation of zero means that the two things are random with respect to each other. It doesn't mean that one stays flat when the other goes down, it means that sometimes they go down together, sometimes up together and sometimes one goes up when the other goes down. Basically if something is going up then it has to also go down soon enough or otherwise the entire global asset value will soon be gobbled up by it . Put 1.3 to the power of 100 into a calculator to see what happens if you get a 30% annual return for a century.

[MachineGhost]

I still don't understand why you are backtesting during periods prior to 1971.  The PP is only designed to work in a post-gold standard world.  Testing it in a gold standard era is like testing a BMW on a dirt track--it's simply not designed for those conditions and shouldn't be expected to perform well in that environment.

It is my understanding that HB considered 100 years of history in designing the PP and that included the period of fixed exchange rates (which is confused by gold bugs as the "gold standard").  The only difference between now and pre-1971 is that gold was cash and vice versa.  The PP does not hold cash, so it should not be an issue to avoid looking at its performance under different economic scenarios in the past.  At some point in the future, the world is going to go back to a fixed exchange rate system.  In my view, the PP cannot truly be "Permanent" unless it can deal with all possible future conditions.  I want to fix potential problems ahead of time and not wrangle in agony later while its happening.

But what is the rationale for semi-numismatic coins in the first place?  Bullion gives you the exposure you need.  There is no need to assume the added risk of fluctuating premiums to spot price that semi-numismatic coins offer.

Well, it is a market distortion.  And market distortions do not last as people profit by arbitraging the difference away.  This is an example of what I meant by active management vs passive.  It is still effectively bullion as long as one doesn't overpay the premium.  Situations like this arise in the markets occasionally.  Should we all be so blindingly pure as strict Browneheads that we never take advantage?

Part of what is impressive about the PP, though, is that during the period for which it was designed--i.e., post-1971--it has performed well when virtually every other allocation has let investors down at some point.

I don't know if I would call the PP "impressive" given its real return weaknesses that I've tried to bring to light in this thread, but its relative performance vs Wall Street's endless B.S. is certainly impressive.

The PP wold not have been appropriate for "money you can't afford to lose" in the 1938-1951 time frame.  Since 1971, however, the PP has proven to be a near perfect location for "money you can't afford to lose." 

Okay, you keep making this claim.  So exactly what agnostic of the future portfolio composition do you propose to weather a 1938-1951 style period?  That is the biggest bug the PP has.  If we all just need a little secondary hard asset exposure, like timber, to complement the gold, then problem solved.

MG

[MachineGhost]

daily 30 year yield data since 1977 http://uk.finance.yahoo.com/q/hp?s=^TYX

I can't figure out how to convert daily yields to total return data.  The resulting numbers seems to be on orders of magnitude 2x-3x actual reality, even a simple division by 365.25.  Furthermore, Excel 2003 will not deal with exponents/powers past 300 and the Price function doesn't seem to work on daily.

MG

[HB Reader]

I still don't understand why you are backtesting during periods prior to 1971.  The PP is only designed to work in a post-gold standard world.  Testing it in a gold standard era is like testing a BMW on a dirt track--it's simply not designed for those conditions and shouldn't be expected to perform well in that environment.

It is my understanding that HB considered 100 years of history in designing the PP and that included the period of fixed exchange rates (which is confused by gold bugs as the "gold standard").  The only difference between now and pre-1971 is that gold was cash and vice versa.  The PP does not hold cash, so it should not be an issue to avoid looking at its performance under different economic scenarios in the past.  At some point in the future, the world is going to go back to a fixed exchange rate system.  In my view, the PP cannot truly be "Permanent" unless it can deal with all possible future conditions.  I want to fix potential problems ahead of time and not wrangle in agony later while its happening.

But what is the rationale for semi-numismatic coins in the first place?  Bullion gives you the exposure you need.  There is no need to assume the added risk of fluctuating premiums to spot price that semi-numismatic coins offer.

Well, it is a market distortion.  And market distortions do not last as people profit by arbitraging the difference away.  This is an example of what I meant by active management vs passive.  It is still effectively bullion as long as one doesn't overpay the premium.  Situations like this arise in the markets occasionally.  Should we all be so blindingly pure as strict Browneheads that we never take advantage?

Part of what is impressive about the PP, though, is that during the period for which it was designed--i.e., post-1971--it has performed well when virtually every other allocation has let investors down at some point.

I don't know if I would call the PP "impressive" given its real return weaknesses that I've tried to bring to light in this thread, but its relative performance vs Wall Street's endless B.S. is certainly impressive.

The PP wold not have been appropriate for "money you can't afford to lose" in the 1938-1951 time frame.  Since 1971, however, the PP has proven to be a near perfect location for "money you can't afford to lose." 

Okay, you keep making this claim.  So exactly what agnostic of the future portfolio composition do you propose to weather a 1938-1951 style period?  That is the biggest bug the PP has.  If we all just need a little secondary hard asset exposure, like timber, to complement the gold, then problem solved.

MG

MG -- I started reading HB's books in 1974 and took his newsletter from 1980-1995.  His books, graphs and commentaries were all clearly geared toward the world after the fixed dollar/gold link at $35 per ounce was broken.  In other words, today's world -- a world of fiat currencies whose issuance is controlled by central banks that are the political/legal captives of their national governments.  HB clearly meant "permanent" in that context.  Whether that qualifies as "permanent enough" is something for each of us to decide.  It comes as close to permanent as any strategy I've run across, especially with it's allowance for a Variable Portfolio in which to speculate. 

HB would've been among the first to advocate investors rethink the PP strategy if a return to something like the old Bretton Woods (or earlier) system(s) had ever become a real possibility.  He also stated a number of times that the PP wouldn't guarantee a real profit every year -- no such certainty exists for any investment stategy in the real world. 

Who knows whether we will ever have a fixed exchange rate or gold-based (or some other) system in the future?  Maybe we will, maybe we won't.  I haven't heard much discussion about it.  Certainly anything is possible, but it seems a little unrealistic to me to speculate about it at this point.   

I'm not suggesting timber or some other commodity is a good or bad investment, just that I'm pretty sure HB would have suggested making that bet in one's Variable Portfolio.  Using semi-numismatic coins (if you can get them with low enough premiums) for the gold in your PP isn't a terrible idea, but it is probably a little more trouble than most people want to go to and, in my experience as a coin collector, much more difficult to exploit than it appears on the surface.       

[Gumby]

I still don't understand why you are backtesting during periods prior to 1971.  The PP is only designed to work in a post-gold standard world.  Testing it in a gold standard era is like testing a BMW on a dirt track--it's simply not designed for those conditions and shouldn't be expected to perform well in that environment.

It is my understanding that HB considered 100 years of history in designing the PP and that included the period of fixed exchange rates (which is confused by gold bugs as the "gold standard").  The only difference between now and pre-1971 is that gold was cash and vice versa.  The PP does not hold cash, so it should not be an issue to avoid looking at its performance under different economic scenarios in the past.  At some point in the future, the world is going to go back to a fixed exchange rate system.  In my view, the PP cannot truly be "Permanent" unless it can deal with all possible future conditions.  I want to fix potential problems ahead of time and not wrangle in agony later while its happening.

It wouldn't make any sense to hold a Permanent Portfolio under those circumstances. The idea that anyone would be satisfied with 25% of their money in cash and 25% in a cash equivalent is kind of ridiculous.

It's highly unlikely that the world is going to go back to a fixed exchange rate system. Even if we wanted to it would be incredibly difficult to implement at this point. HB talked about this on his radio show.

Also... Harry Browne supposedly tested many different periods of time when devising the Permanent Portfolio. That doesn't mean that he made a whole 100-year backtest of the PP. It doesn't even mean that he backtested a US market. It just means that he likely studied how stocks, gold and bonds reacted during periods such as the Panic of 1873, Weimar Republic hyperinflation, WWI Poland, the Great Depression, etc. etc.

Anyone who shows you a 100-year or 200-year backtest to prove something is just showing you a long string of major economic and demographic events that will probably never happen again (the Industrial Revolution, the Baby Boom, the Great Moderation, etc.). Shorter blocks of data (i.e. 1916-1923, or 1929-1942) can often be more helpful for stress-testing than something like 1900-2011.

[MediumTex]

RE pre-1971 allocations: If I had to put together a portfolio for a period like 1921-1971 I might start with something like 33% cash (i.e., short term treasuries), 33% stocks and 33% long term treasuries and see how that performed as a starting point.  I think, however, that the 30 year bond wasn't available during parts of this time period.

RE future currency pegs: Given disasters involving currency pegs in Argentina and more recently in the EU, it would surprise me if the whole world embraced currencies pegged to gold any time soon.  If anything, it seems like we are moving farther away from that, rather than closer (i.e., central banks are attempting to exert more control over currencies, not less). 

RE capturing semi-numismatic coin premium expansion/compression: If you are looking for something like this within the gold allocation, I might try to play the GTU premium spread rather than messing around with semi-numismatic coins.  It seems like it would be a more liquid and convenient way to accomplish the same thing (plus you potentially have better tax treatment with GTU).

[MediumTex]

BTW, MachineGhost, I very much appreciate your PP skepticism.

Whether or not you are personally persuaded by the responses above, I think that you are teeing up a lot of issues that many aspiring PPers will probably find useful as they read this forum.

[MachineGhost]

RE pre-1971 allocations: If I had to put together a portfolio for a period like 1921-1971 I might start with something like 33% cash (i.e., short term treasuries), 33% stocks and 33% long term treasuries and see how that performed as a starting point.  I think, however, that the 30 year bond wasn't available during parts of this time period.

That seems reasonable to me.  Lets look at the pre-1971 history in terms of real performance:

[img width=600]http://img20.imageshack.us/img20/610/333333t.gif[/img]
Despite the title, this is a 33/33/33 portfolio.

Well then, when cash == gold, another hard asset definitely needs to take up the role for which gold performs in the PP today.  That actually makes perfect sense to me under the equilibrium theory.  So I will complement a large core gold position with minor positions in other hard assets and re-evaluate their sizing if gold ever becomes illegal or fixed to cash again.

Here's an interesting question:  What percent of the 25% of each asset is infinitely permanent because it will never be touched upon when reallocating or not relatively reduced below by growth in the other assets?

RE future currency pegs: Given disasters involving currency pegs in Argentina and more recently in the EU, it would surprise me if the whole world embraced currencies pegged to gold any time soon.  If anything, it seems like we are moving farther away from that, rather than closer (i.e., central banks are attempting to exert more control over currencies, not less). 

We are actually a long ways off of going back to a fixed exchange system if history is any guide (20 years give or take), but I am taking a very long-term view with the PP as I expect my lifespan to be quite lengthy.  I don't want any future surprises with a "set it and forget it" portfolio because I was intellectually lazy at the outset.

RE capturing semi-numismatic coin premium expansion/compression: If you are looking for something like this within the gold allocation, I might try to play the GTU premium spread rather than messing around with semi-numismatic coins.  It seems like it would be a more liquid and convenient way to accomplish the same thing (plus you potentially have better tax treatment with GTU).

Excellent idea!  The liquidity issues with physical gold are a royal pain...

MG

[MachineGhost]

BTW, MachineGhost, I very much appreciate your PP skepticism.

Whether or not you are personally persuaded by the responses above, I think that you are teeing up a lot of issues that many aspiring PPers will probably find useful as they read this forum.

I am persuaded, but I now believe more levity in the hard assets area is warranted by historical evidence than in the "Short Bonds" allocation.  The "risk free" rate is ridiculously high with I-Bonds, so additional risk is barely rewarded with significant return in many of the alternatives when viewed from a discounted cash flow basis.  Now, if I was using "risk free" T-Bills or CD's solely as a reference point, then things could look a lot different.  But, the fact that one can put a large allocation of one's wealth into "risk free" assets to begin with places a high watermark to overcome for alternatives that are just riskier enough that only relatively small investments can be made into them to keep the overall asset class at risk parity.

Lets take corporate bonds for example.  Many of the ultra short high grade ones right now do not even have yields to maturity that surpass inflation and thus neither I-Bonds.  The minimum investment for corporate bonds is also $1000 per bond vs $25 for I-Bonds.  That's a 40x larger size that would tear out more than a pound of flesh if just one went into bankruptcy.

I don't necessarily believe that a continous soft default via inflation in "risk free" assets is guaranteed in the future.  All it will take is existing creditors to reduce or stop buying U.S. debt and a hard default will happen virtually overnight as it has in the PIIGS.  But since there is no effective way to deal with that risk short of avoiding government liabilities alltogether, we'll leave it to the gold to take up the slack.  The question then becomes is 25% gold really enough to offset the other 50%-75% in real terms?  Iceland's experience proves it is not.

MG

[stone]

Machine Ghost, in the UK QE entirely makes up for our increasing government debt so the bank of England buys up treasury bonds as fast as the treasury issues them. That seems to me the polar opposit of what the PIIGS are facing. The bond market knows that and that is why they short Italian etc bonds not UK, Japanese, Icelandic,  US etc etc bonds.

[MediumTex]

MachineGhost, is that 33%x3 chart above real or nominal returns?

[moda0306]

I am just going to throw out there that I think in a gold standard world you'll want to have the following two considerations with the PP.

1) Risk of dropping gold standard while holding cash: I think you still want some gold... maybe not 25%, but after seeing governments dropping the gold standard like mad during the 30's, I think it's safe to assume that from an investor's point of view there is no such thing as a gold standard... it is simply another promise that can and probably will be broken.

2) Risk of default by gov't makes long-term treasuries much less attractive: Look at Europe now... periphery countries might as well be on a gold standard.  Your long-term treasuries simply aren't going to work the way they do when a gov't can print money.  Of course, this somewhat flies in the face of #1, because I just said they'll eventually probably dump the gold standard, but the markets aren't going to allow a country with large deficits and debt within a gold standard get away with 2.9% interest rates on 30 year bonds.

All that said, it's obvious that it'd be tough to construct a PP in a pegged or gold-standard world, because you are somewhat relying on the gov'ts promise to keep that standard, and the market is somewhat expecting possible default if the gov't doesn't drop the gold standard in the wake of a crisis.  I don't know how exactly I'd invest if we were in a gold standard today.

[stone]

moda, if we were in a gold standard world I guess it would be best to be  25% stocks: 75% gold. I don't think debt works in a gold standard world- default is a racing certainty.

[moda0306]

stone,

I like the implications of your post, and find it quite funny to think that you add more, not less, gold into a portfolio within a gold standard gov't. 

I am of the simple opinion that we don't want our currency pegged to something, making our government's finances as prone to systemic risk as corporations and households, so I agree that a gold standard wouldn't work.  That said, I absolutely believe in owning it at the individual level (obviously, being a hardened PP supporter).

I think these are things that some PP'ers agree with (though obviously not all), and it's an interesting set of beliefs to approach others with... "I think a gold standard would be a disaster, but put 25% of your wealth in gold!... PS, I think hyperinflation is implausable and we'll have a long drawn out deflation."

You'd be laughed out of the room.

[MachineGhost]

MachineGhost, is that 33%x3 chart above real or nominal returns?

It was real returns.  Just on a lark, I decided to do 25x4 with AAA corporate bonds instead of gold:

[img width=600]http://img408.imageshack.us/img408/990/pp2v.gif[/img]

Not much difference.

Real Averages Since 1928
Inflation Stocks T-Bills T-Bonds C-Bonds Gold
3.19% 8.00% 0.56% 2.56% 2.75% 4.03%

MG

[MachineGhost]

moda, if we were in a gold standard world I guess it would be best to be  25% stocks: 75% gold. I don't think debt works in a gold standard world- default is a racing certainty.

[img width=600]http://img827.imageshack.us/img827/3554/2575.gif[/img]

[MachineGhost]

PS, I think hyperinflation is implausable and we'll have a long drawn out deflation."

Hyperinflation can only occur by dropping all respect for the "Bond Market Vigilantes" and directly creating bonds by finger-snap or printing up paper currency and paying people with this money directly.  This does not seem very probable in Western countries that have institutions and so-called "rule of law" without first an extremist regime change.  Zimbabwe is a wonderful example.

MG

[MachineGhost]

25x4 with silver instead of gold.
[img width=600]http://img809.imageshack.us/img809/1205/silverz.gif[/img]

Real Averages
Inflation Stocks T-Bills T-Bonds C-Bonds Silver Gold
3.19% 8.00% 0.56% 2.56% 2.75% 7.47% 4.03%

Without the outlier 434.79% spike in 1979, silver's real average return would have been only 2.29%.  Likewise for gold.

Using a simple risk/reward heuristic by allocating the 25% to 13.20% gold and 11.80% silver would have resulted in a real CAGR of 3.73% and a better reward/risk ratio than the standard 25x4.  So adding some silver seems to help at first glance, but once the outliers are taken out of play, gold is preferred 100%.
[img width=600]http://img9.imageshack.us/img9/5513/image001mmm.gif[/img]

[MachineGhost]

Here is a chart for an optimized real return portfolio among all the asset classes I've included so far (no correlations taken into account).  Real CAGR is 4.27%.  The AAA high grade corporate bonds are 20-30 year maturities.

Weights
Stocks T-Bills T-Bonds C-Bonds Silver  Gold Total
27.35% 0.00% 0.00% 60.16% 6.88% 5.61% 100%

[align=center][img width=600]http://img5.imageshack.us/img5/1814/optimized.gif[/img][/align]

[MediumTex]

MachineGhost,

Am I reading that chart above correctly that the allocation you are describing had 0% real return for the 15 year period between 1936 and 1951?

That's a long time to see zero return on your investments.

[gap]

Looking at past data and optimizing returns may be dangerous if you do not include some measure of risk, e.g. std deviation or a Sharpe ration.
It is hard to compare different allocations/strategies without the above. As a minimum it would be nice to see
Returns
Std Deviaton
Max Drawdown
and if possible MAx Drawdown duration

[MachineGhost]

I do not know why I didn't notice this before, but it is obvious now that the period 1934 to 1954 that the HBPP incurred severe real losses during was one of negative real interest rates, akin to the hoarding of the 1970's and also occuring presently.  So no real mystery after all.  Gold would have responded just dandy if legal to transact in.

1934.00 -0.37%
1935.00 -2.74%
1936.00 -1.29%
1937.00 -2.73%
1938.00 2.91%
1939.00 0.03%
1940.00 -0.67%
1941.00 -9.99%
1942.00 -8.71%
1943.00 -2.58%
1944.00 -1.92%
1945.00 -1.87%
1946.00 -17.75%
1947.00 -8.60%
1948.00 -2.09%
1949.00 3.25%
1950.00 -4.89%
1951.00 -4.76%

MG

[MachineGhost]

DecisionMoose's performance has sucked ever since it was investigated and publicized by CXO a few years ago.  It may be failing.  Either way, its worst historical drawdown is around 25%, not for the faint of heart.  It has a limited history and how will you know when it reaches the point of total failure?  At 50% maximum drawdown?  There goes a 10% loss of your net worth that the HBPP wouldn't have experienced.

I don't see the logic for Small Cap Value -- it sounds like its from one of those lazy portfolio journalist maroons (Swedhoe?) data mining over a limited testing history and who never reads any up-to-date academic research.  Why not microcaps?  Why not frontier countries? etc.  But anyway, the proper logic is to use the actual market anomalies which rule out size and value as the French and Fama factors are horribly outdated.  But this all really has nothing to do with diversification, only the relative maximum growth of equity.  All equity acts alike and all equity drawdowns are similar.  Anyone can minimize fat tails by curve fitting to history; the question is if the history is representative enough?  It's a definite no for Simba's spreadsheet.

And the added portfolio complexity you are suggesting is a headache.

Lets get real for a minute.  Stocks had a maximum drawdown of 90% or so in real dollar terms during the Great Depression.  Bonds had a maximum drawdown of 80% or so in real dollar terms during the go-go 60's.  Stocks have had a maximum drawdown of 85% or so in real dollar terms since Jan 2000.  Those are just about the worst case scenarios you can imagine and the HBPP seems to have come through with flying colors.  In what world is it going to have a 50% maximum drawdown?  Its weakness during the late 30's to early 50's was during a time of a slowly recovering then faltering economy (due to austerity and tax increases), then a world war and then robust economic growth.  None of that was bad to the portfolio per se, only the negative real interest rates.

I only have timberland data back to 1960.  It is just not long enough to say for sure it will act as a substitute for gold being illegal.  Timberland investments are illiquid and lockup periods are typically 10 years.  I suspect diamonds have a better chance of working out in practical terms as they're the most dense form of wealth, but good luck finding any historical data.  Diamonds saved the Vietnamese refugees after the fall of Saigon.  Before that, only soap and cigarettes were in more demand.

It's not like the HBPP has or will fail, its just that what is suggested as a default for each of the four asset classes is not always the best investment.  Alternatives are hard to model without sufficient historical data though.  For now, I see no compelling justification to change the basic 25x4, but more diversiity in the Real Asset class is certainly prudent.

MG

Assuming the PP is not as safe as many perceive it to be - i.e. it could perhaps encounter drawdowns of -33% or even -50% at times (as I personally believe is a real possibility), the next best 'improvement' IMO is to not fully load only into a PP and instead diversify more widely.

40% allocation to Fat Tail Minimisation (30% Small Cap Value, 70% TIPS), 40% PP and 20% Decision Moose seems to me to be a reasonable choice.

That blend/combination could expand total stock exposure up to approaching 50% total weightings at times, but only when stocks were in relative strength (Decision Moose holding stocks). For gold and LTT's the upper weightings would be limited to around 34% maximum weighting i.e. PP based gold at perhaps 14% exposure levels, up from 10% target weighting and at/near a 'reduce' PP rebalance event + 20% if DM was IN gold. And 34% weightings is similar to what a 100% PP allocation might at times hold in any one single asset.

The diversification also potentially opens up better domestic currency risk diversification. For example as a UK resident I might hold 40% in a UK PP, 20% DM in US and FTM perhaps on a global version basis - and currency motions might generate further 'rebalance benefits' (re-levelling back to 40/40/20 weights).

Since 1996 it would appear that blend yielded over a 9% real reward, whilst in 2008 it was down -2%, so the extra diversity could yield higher rewards potentially with less overall risk.

[stone]

Clive, what would have survived WWII? That person who buried gold coins in a London garden from 1938 until 2007 did OK I suppose. Would gold coins have been taxed in 1940s UK? Perhaps South American stocks would have sailed through that period It seems to me to be a bit farfetched to hope to have an investment strategy that copes with something like WWII. I'm hoping to wriggle past Wall Street, I'm not kidding myself that the PP is up to the task of wriggling past Hitler.

[moda0306]

Clive,

With gold gaining 4.3% even on the dollar in 2008, at 25% with 10% bands, how on earth did the Iceland PP lose 75% of its purchasing power?