Why PP works, even though Gold/Cash have long-term 0 net expected return

[TripleB]

One of the biggest anti-PP comments I read is that gold has a long-term net return of $0. Cash has a long-term inflation-adjusted net return of $0. Stocks and bonds are the only asset that has a positive long-term net return.

My response is that yes, "I agree" in principle. Stocks *must* have a long-term positive net return. Stocks represent the economy. If stocks were to drop 10% per year, in perpetuity, it would mean that businesses are destroying value and eventually the world would end.

Profits, in an economic sense, are a creation of value. A business buys raw materials (or hires untrained employees), does some kind of change event on those materials (or trains employees), and then sells the finished product (or service), at a price that is higher than the business spent to create that product or service. The transformation event that the business performed is value to society, and is represented by profit. If a business is not profitable, it means that they are only able to sell their final goods (or services) for less than the business paid in raw materials. Thus, the business destroyed economic value.

If businesses as an aggregate continually destroy value over long periods of time, there will be nothing left of value in society. Thus, while possible for the stock market to exhibit long-term losses, it would result in the collapse of society, and there would be no investing solution to this problem. The answer is guns, ammo, and stored food (which I believe one should own).

Thus, the premise is that stocks must return a positive gain in the long term, if society is not destined to collapse. In that case, yes, stocks are a better long-term investment than gold or cash, because as stated above, there is no positive inflation-adjusted return on either cash or gold.

The problem with the anti-PP view, is that the length of time required for something to be a "long-term" investment may exceed that of an individual's time horizon. It's possible that the stock market could lose money for 10, 20, or maybe 30 years and not cause a societal collapse. Economic value is being destroyed, however not quiet enough to destroy societies globally.

The purpose of gold and cash is to buffer losses in the stock market. Thus, if the stock market drops over long periods of time, the gold portion rises, allowing someone to sell gold at a gain, lock in the profit on the gold sale, and purchase more stocks at a low price.

This brings up the final point. While gold may have a long-term net increase of $0 real dollars, it could experience short term gains (or losses). If someone buys gold at $1800 an ounce and sells it at $1500 an ounce if the market drops over the course of 1 month, they lost real money. Non-PPers will always argue that gold is "dangerous" because it could be in a bubble.

The only way for this to be true (which I believe it is true), is if the inverse is true, that someone has the ability to buy gold, and sell it in the short-term for a profit. Thus, gold may have a long-term change of $0, but a short-term profit.

The PP guarantees that gold is only ever sold at a profit, because it's only sold when it hits a high rebalance band. Thus, by default, you can *only* profit on gold within the PP.

[Roy]

It comes down to the timing of correlations.  Commodities (including CCFs) can improve the total portfolio return—even during periods in which the commodity posted a negative return. And this is not always clear when viewing only yearly returns of individual asset classes.

The arguments about Gold's zero expected return, and even tracking inflation poorly over long periods, are not convincing when viewing the portfolio as a whole.  I find it amusing that some who preach this very holistic way of viewing the portfolio, can choose to view things in isolation when they simply don't like, or understand, a specific asset class.  

[TripleB]

.. and if you'd bought gold in 1980 - you'd still be waiting to break-even on that trade in real terms more than 31 years later - let alone having made any profit.

Is that true only as gold in isolation, or as gold within a rebalanced PP? I'm assuming as gold went down after 1980, you would be selling your winning asset to buy more gold, and then as gold went up comparative to the other assets, you sold gold to buy the losers. Thus you made a profit, post-1980 on gold. Unless I am mistaken?

[Indices]

I'm not sure if I believe in expected returns. In the 19th century stock and bond returns were nearly identical. Then in the 20th stock returns grew and bond returns fell. Most of the data for expected returns comes from only the last few decades of experience. The concept of expected returns stems from recent past performance, which isn't necessarily relevant to the future.

[MediumTex]

RE the stock market:

Let's say I am a Japanese investor.  My name is MediumTex-a-son.  I am 61 years old.

When I was a younger man, I didn't save enough, but when I was 40 I decided to turn over a new leaf and start putting away a significant part of my earnings.

Being Japanese, I am cautious by nature so before beginning my investing career I read all about investing and only listened to the smartest people (who were, naturally, Japanese).

As I studied the markets and investing, it became very obvious to me that Japan was the world's next superpower.  In the late 1980s it was clear that the sun was setting on the U.S.'s power, and Japan was the obvious successor.  As I looked back into history the analogs between Britain in the 19th century and Japan in the 21st century were almost too obvious, except that Japan's imperialism would be of a peaceful economic nature and the amount of wealth to be harvested from getting ahead of the globalization trend was simply mind boggling.  Many of the companies in the world poised to benefit from these changes were in Japan.

In the early 1990s, I couldn't believe how lucky I was.  I had somehow been given the gift of buying stocks on the Nikkei during what was clearly a once in a lifetime opportunity to buy world class companies at a deep discount.  I only bought Nikkei index shares, because that's the way to mitigate risk while capturing the return of the whole market.

As the 1990s and then the 2000s progressed, my luck continued, and I bought as much of the Nikkei stock market as I possibly could.  I knew these depressed price levels couldn't continue forever.  Even though I was deeply in the red from an investment return perspective, the stock market experts I talked to said that this was a good thing, and it meant that I was picking up stocks very cheaply.  They told me in hushed tones that the stock market ALWAYS provided superior returns over the long term.

So here I am today.  My portfolio is worth 30-40% less than the total of my contributions over these last two decades.  I would like to retire some day, but my retirement savings are worth vastly less than all of the projections I was using when making my investment decisions.

I would ask my investment advisor what I should do, but he committed hari kari toward the end of 2008.

Can anyone here tell me what went wrong with my strategy?  Have I not been patient enough?

I have a friend in the U.S. who has been following a strategy similar to mine, except he only buys S&P 500 index shares, and he only started his investing career in 2000 (he's been getting some AMAZING deals on stock these last 10 years).  He's 51 now.  I will pass along to him whatever advice you give me.

[Indices]

I LOL'D at the Hari Kari part.

Japan shouldn't be happening. Stocks are supposed to have higher returns than comparable government treasuries. Until they don't. I am shocked that what is going on there has not turned modern portfolio theory on its head. The whole philosophy advocated by many prominent scholars and authors is completely wrong.

[MediumTex]

There is also the matter of the NASDAQ.

Imagine a young investor entering the market in 1999.  It would have made sense to only buy a NASDAQ index fund, since the future was going to be all about technology, the internet, computers and information management. 

An investment in the NASDAQ should have provided superior returns to a broader market index, and conventional investment wisdom says that by taking on greater risk we will get greater returns over time.

Well, 12 years have passed, and the NASDAQ would need about a 100% gain from its current level to reach the level it was at a decade ago.

What happened?

[MediumTex]

IMO there is a real risk that the PP as a whole is not as correlated with inflation as some might believe. Yes the nominal returns are generally smooth, but in real terms there have been historic instances of losing 25% of purchase power over decade+ long periods.

Clive,

The appeal of the PP is that it has provided very stable nominal AND real returns since 1971. 

What periods are you looking at where the PP has lost 25% in real terms over decades-long periods?

I don't think that your synthetic pre-1971 silver PP backtesting results should count.  The PP is a fiat world strategy.  If we were on a gold standard, I don't think the PP would be nearly as appealing.

[doodle]

Clive,

If treasury yields are artificially depressed below the rate of inflation...what safe asset class would you recommend holding? I would imagine that cash would also be a losing proposition.

[MediumTex]

Can anyone here tell me what went wrong with my strategy?

Tex-o-san, you foolishly bought into an asset that has endured recent very strong gains!

1972 to 1983 Japanese stocks had risen nearly 5-fold in nominal terms. A bit like gold having risen 6 fold in the last decade or so. Did you not remember how the roaring 20's were followed by the heavy losses in the 1930's. Anything that goes up hard and fast can come back down hard and fast.

Having perhaps bought stocks in 1983 by the end of 2007 the investor had seen nowhere near those historic levels of growth, having to accept just a low 4% annualised real reward.

But Master Clive, how am I to know beforehand whether recent strong gains are going to continue or reverse?

[stone]

Clive, "1936 to 1953 for example. Across the 1940's real rates of return were poor due to Fed intervention, with something like 18% inflation in one year, 10% in another, whilst treasury yields were held at 2% type levels. That dragged down stock and bond real gains by amounts that few if any other assets would have counterbalanced those losses."

I think the take home message is that war is wasteful. Not all that surprising but true nonetheless. The shocking thing though is that perhaps post war prosperity depended on the waste and destruction of WWII rebooting the system. WWII reduced wealth inequality dramatically. I keep thinking that the trick to getting a sustainable economy is to find some peaceful way keep a lid on increasing inequality.

[smurff]

Is that true only as gold in isolation, or as gold within a rebalanced PP? I'm assuming as gold went down after 1980, you would be selling your winning asset to buy more gold, and then as gold went up comparative to the other assets, you sold gold to buy the losers. Thus you made a profit, post-1980 on gold. Unless I am mistaken?

You would have been selling part of the bubbly gold allocation in 1979-1981 at 700 to 800+ nominal dollars per ounce, and buying stock with the proceeds.  And in 2002, you would have been buying up cheap gold for 200 nominal dollars per ounce with some of the appreciated stocks you bought with the gold in 1980.  In 2011 you can sell some of the gold for 1800 nominal dollars per ounce and buy some more stocks, or cash, or whatever part of the portfolio needs balancing.

Whatever dancing your gold has done in the past 30 or so years, you would still have a portfolio worthy of the capital you put into it.