Requiring high volatility in stock investments

[Donald]

I am very happy to have found this forum and I appreciate the time you put into expanding upon Harry Browne's lessons.

I hope you can help me understand a change Browne made to his system that completely baffles me. I think I understand why he recommends each asset class and the equal split among them. I thought I understood that the particular investments in each class needed to be highly volatile in order to allow that class to lift the entire portfolio when its turn came. So, for example, he requires long-term Treasuries since they are more volatile than short-term bonds.

But for stocks, his recommendations changed from 1987-2003 [details below] and, instead of recommending stock investments that are more volatile than the general stock market, he started recommending S&P 500 index funds.

Doesn't that give up the high volatility necessary for the stock allocation to do its job?

I've listened to 18 of the radio shows in the archive but have yet to hear an explanation for the change. I figured you would know.

Thank you for your insights.

Don

References:

1987

In Why the Best-Laid Investment Plans Usually Go Wrong, Harry Browne says (page 329):

"For the Permanent Portfolio, a stock-market investment should have these attributes:
...
2. Volatility: The investment should move further and faster than the general stock market. With this volatility, a small budget can earn a large profit--more than offsetting the losses prosperity would inflict upon other parts of the portfolio...."

On page 336, Browne provides a list of volatile stocks with betas from 1.30 to 1.85. He then discusses mutual funds and the first attribute he suggests we look for (p. 337) is

"1. Volatility: The fund should move in the same direction as the general stock market--but farther and faster. For reasons discussed in Chapter 2, past performance isn't a sure guide to future volatility. But if a fund has a policy of pursuing high growth and has achieved high growth during past bull markets for stocks, it probably will be volatile in the future...."

On page 340, he suggests seven "very volatile" mutual funds.

1999

In Fail-Safe Investing, Harry Browne says (page 108):

"... In addition you want funds that invest in volatile stocks, in the hope they will move farther than the general stock market when times are good."

On pages 156-159, Browne lists eight funds meeting his qualifications and notes they are the same funds as in 1987 with the addition of the Aggressive Growth Portfolio from the Permanent Portfolio Family of Funds.

2003

In Fail-Safe Investing, Second Edition Harry Browne omits any mention of volatility as a qualification and says (page 73):

"The most appropriate mutual funds are the S&P index funds. These funds
duplicate the return you’d get if you could purchase all the stocks in the Standard
& Poors 500 Index — an index that provides a good representation of the entire
stock market."

In Appendix B on page 106, Browne writes

"As discussed on page 72, the stock-market portion of your Permanent
Portfolio should be invested in a way that mirrors the performance of the general
stock market. That is, you want to be sure that when the broad market goes
upward, your holdings appreciate correspondingly."

Gone are the funds he recommended from 1987-1999 and in their place are a set of eight S&P 500 index funds.

[Gumby]

Volatility: The investment should move further and faster than the general stock market. With this volatility, a small budget can earn a large profit--more than offsetting the losses prosperity would inflict upon other parts of the portfolio...."

Welcome!

The problem with that advice is that nobody can accurately predict which funds will beat the market during prosperity. In 1999 there were a lot of high flying technology stocks that broke a lot of preconceived rules about how companies grow and are valued. It's unlikely that many of Browne's stock mutual fund recommendations beat the S&P 500 during the intense prosperity of the 90s. I suspect Browne realized after 2000 that capturing prosperity was harder to implement than he originally thought and changed his approach to capture prosperity in a broader format. This allowed him to focus on selling a portfolio that required no speculation whatsoever.

Of course, I'm just speculating on what must have been going through his mind.  ;)

[melveyr]

Yes, the change is curious. I think he reached the conclusion that it is hard to discern ahead of time which stocks are going to be more volatile than the market. Another thing is that when he first started indexes were not very popular. The amount of research we have now on indexes probably swayed him.

If I were to tweak the PP, and I might do so in the future, I would be inclined to go 12.5% large cap and 12.5% small cap. If you are comfortable assuming that small caps have a higher beta, than this logic is line with his original line of thinking.

For now I'm plain vanilla PP.

[AdamA]

For now I'm plain vanilla PP.

The plainer and more vanilla the better, IMO.

The reason for the change in stock funds was/is that just because something has been volatile in the past doesn't mean it will be volatile in the future.  It's not uncommon for each slice n' dice portion of the stock market to show very high volatility relative to the S&P for a decade or two, and then suddenly much less for a decade or two.   

The S&P is volatile enough on it's own to be suitable, and most of the index funds that track it are tax efficient and relatively low expense. 

[HB Reader]

In addition to the points above, I think buying a broad index is more in keeping with HB's views about the difference between investing and speculating.

FWIW -- During the 1980s & 90s I periodically reviewed the mutual funds HB suggested as stock investments for the PP.  As a group they generally seemed to perform as he suggested they would, but as a practical matter it wasn't that simple.  Most of them chose stocks based on the manager's views about the next hot sector or some other factor, not whether the fund would maintain a consistently high beta.  The managers changed periodically and sometimes the funds would appear to experience some "style drift" to a degree.  You probably would have had to invest in five or more and rebalance them with iron discipline to consistently get returns more volatile than the overall market.  In short, they required more monitoring/judgment/switching (the hassle factor) than it appeared on the surface.  I suspect HB finally decided between 1999 and 2003 that it wasn't worth the effort and that you would catch the lion's share of market advances with simple index funds. 

Although I don't know it for a fact and haven't researched it, it appears to me that the beta measurements of individual stocks are more consistent over long periods of time than the beta of individual mutual funds.  So if you want consistently high beta, you probably need to choose a diversified portfolio of stocks on your own.  That is more than most investors are willing or capable of doing.  There are some "high beta" mutual funds and ETFs, but most of them seem to be that way as a side effect of the managers current style.  If anyone knows of some large diversified funds or ETFs that consistently and explicitly (i.e., as part of their charter) use beta to choose their stocks, please post the names.  They may bear looking into.  All in all, though, it appears difficult to improve on a broad index (like SPY or VTI) if you want simplicity.

[MCSquared]

In addition to the points above, I think buying a broad index is more in keeping with HB's views about the difference between investing and speculating.

FWIW -- During the 1980s & 90s I periodically reviewed the mutual funds HB suggested as stock investments for the PP.  As a group they generally seemed to perform as he suggested they would, but as a practical matter it wasn't that simple.  Most of them chose stocks based on the manager's views about the next hot sector or some other factor, not whether the fund would maintain a consistently high beta.  The managers changed periodically and sometimes the funds would appear to experience some "style drift" to a degree.  You probably would have had to invest in five or more and rebalance them with iron discipline to consistently get returns more volatile than the overall market.  In short, they required more monitoring/judgment/switching (the hassle factor) than it appeared on the surface.  I suspect HB finally decided between 1999 and 2003 that it wasn't worth the effort and that you would catch the lion's share of market advances with simple index funds.   

Although I don't know it for a fact and haven't researched it, it appears to me that the beta measurements of individual stocks are more consistent over long periods of time than the beta of individual mutual funds.  So if you want consistently high beta, you probably need to choose a diversified portfolio of stocks on your own.  That is more than most investors are willing or capable of doing.  There are some "high beta" mutual funds and ETFs, but most of them seem to be that way as a side effect of the managers current style.  If anyone knows of some large diversified funds or ETFs that consistently and explicitly (i.e., as part of their charter) use beta to choose their stocks, please post the names.  They may bear looking into.   All in all, though, it appears difficult to improve on a broad index (like SPY or VTI) if you want simplicity.

PowerShares just rolled out an ETF (SPHB) that is a high-beta version of the S&P 500.  I have not studied it yet but it is 100 stocks from the S&P 500 with the highest sensitivity to market movements.

[dualstow]

...It's unlikely that many of Browne's stock mutual fund recommendations beat the S&P 500 during the intense prosperity of the 90s. I suspect Browne realized after 2000 that capturing prosperity was harder to implement than he originally thought and changed his approach to capture prosperity in a broader format. This allowed him to focus on selling a portfolio that required no speculation whatsoever.

Of course, I'm just speculating on what must have been going through his mind.  ;)

I think you're on to something there. In a radio show, Harry lays out the contrast between investing and speculation, stating that when you invest, you accept the return that everyone else (who invests) is going to get. The pp already has us down to only 25% stocks, so perhaps he wanted to make sure we captured the market instead of maximizing volatility.

@young mr melvey: nothing plain about vanilla. It's the most awesome flavor on the planet. 

[HB Reader]

PowerShares just rolled out an ETF (SPHB) that is a high-beta version of the S&P 500.  I have not studied it yet but it is 100 stocks from the S&P 500 with the highest sensitivity to market movements.

MCSquared -

Many thanks for the post.  I'm going to watch SPHB for a while.  IMO, it has some potential for the PP. 

[dualstow]

PowerShares just rolled out an ETF (SPHB) that is a high-beta version of the S&P 500.  I have not studied it yet but it is 100 stocks from the S&P 500 with the highest sensitivity to market movements.

MCSquared -

Many thanks for the post.  I'm going to watch SPHB for a while.  IMO, it has some potential for the PP. 

Now you're also "SPHB Reader."

[MCSquared]

PowerShares just rolled out an ETF (SPHB) that is a high-beta version of the S&P 500.  I have not studied it yet but it is 100 stocks from the S&P 500 with the highest sensitivity to market movements.

MCSquared -

Many thanks for the post.  I'm going to watch SPHB for a while.  IMO, it has some potential for the PP. 

No problem.  I have looked at it a little further.  I use FSTVX (Spartan Total Market) and I probably will not change that any time soon (Craig has done a great job emphasizing simplicity both here and at his blog).

Relative to SPHB, the backtesting shows the 60 day rolling beta to average about 1.75.  I think it has potential but it currently has roughly 30% in Financials.  That would bother me but I am interested in hearing your take on it.  As an aside, Powershares also rolled out a S&P low volatility index fund (SPLV) that looks like a 500 value fund based upon the current composition.  It outperformed based upon the backtest but you know the story with backtesting!

[AgAuMoney]

nothing plain about vanilla. It's the most awesome flavor on the planet. 

Mmm, no doubt.  I like a bit of vanilla in my chocolate!