PP vs CD

[ecuadj]

Hi All,

Just wanted to bounce an idea around to see whether there was anything horribly wrong with it. The idea is this:

The PP is for investors who want to protect their capital and are more than happy with a high single digit LT rate of return in order to do so. So if such an investor could find a 5 year CD that paid an equivalent rate of return, should that be a compelling alternative to the PP for those 5 years?

One obvious downside that I can see (and there will doubtlessly be others, which is why I'm asking ) is that you're going to miss out on any big PP years during the term. But the corresponding upside is that you're going to beat any years the PP is down, essentially "locking in" the PP's LT rate of return for the term (rather than "hoping for" it) and you're going to do so with ZERO (rather than low) risk to your capital. And since the PP seems to be first and foremost a capital preservation strategy, upside seems to triumph over downside here (at least for me )

To avoid the risk of one institution going under, let's say you can divide your capital into chunks and invest each chunk with a different institution.

And the other concern that comes to mind is all-your-eggs-in-one-basket currency risk. But isn't this 75% true of any "vanilla" PP (for example, US cash/ST bonds, US treasury/LT bonds, and US stock market - only gold is non-US)?

Anyhoo, thanks for reading, and any advice appreciated!

[hogtied]

Pentagon Federal Credit Union is now taking reservations for their 10 year CD's paying 5% starting in January.  This is where my 25% cash portion is going.  I'm not one to go all in, 100%.

[Reido]

As I see it, that's effectively the same as buying a high-yielding 10yr bond... I believe that 5% is better than you could get for most 10 yr corporate bonds at this point, so it's a very reasonable investment - but you're forgetting one crucial element - the Permanent Portfolio preserves wealth After Inflation!

If inflation kicks up - as is certainly possible since the government has been printing money like it's going out of style - that 5% could get hammered by 8%, 9%, possible double digit inflation.  Historically the Permanent portfolio has been saved by the Gold portion of the portfolio to preserve value during high inflation years.

I presume that you would sell the CD if that did happen - so I'm wondering - how horrendous are the penalties for early withdrawl???

[Pkg Man]

CDs DO NOT have zero risk of capital loss.  As HB mentioned, if there were ever a widespread failure of banks, there is not enough money in the FDIC program to pay everyone.  It might be a very small likelihood, but it is certainly not zero.  That said, I don't see anything wrong with using CDs for part of the cash portion.  But personally I would not use them for all of it.

[hogtied]

listed in the table below.Approximate Yields After Early Withdrawal Penalties at Penfed
Year of Early Withdrawal 10yr 5.00% CD 7yr 4.25% CD 5yr 3.50% CD
year 1                   0%                      0%               1.75%
year 2                             2.47%                   2.11%   2.62%
year 3                             3.31%                   2.82%   2.91%
year 4                             3.73%                   3.18%   3.06%
year 5                             3.98%                   3.39%   3.50% (no penalty)
year 6                             4.15%                   3.54%       n/a
year 7                             4.27%                   4.25% (no penalty  n/a
year 8                             4.36%                     n/a                  n/a
year 9                             4.43%                     n/a                  n/a
year 10                             5.00% (no penalty)      n/a       n/a

So for those who are eligible, is this deal worth it? And which is the best term? The concern is that rates will shoot up in the next few years, and you'll be stuck in the long-term low-rate CD. However, you can always make an early withdrawal with a penalty. If you factor in the penalty, the 10-year CD becomes the best deal if you close the CD from year 3 to 7. Even if you close the 10-year CD at year 2, the resulting APY after taking into account the penalty is very competitive compared to 2-year CDs (2.47% APY). However, if you close the CD any time during the first year, you'll earn no interest. At least with PenFed CDs, they don't eat into the principal.

[MarySB]

I'm not sure I understand your last post.  Are they 1, 2, 3, 4, etc. year CD's?  If so, have you considered laddering them rather than tying up your money for ten years and/or paying penalties?  That way, if interest rates do go up, you can benefit from them with at least part of your cash.  Also, I assume you will have other liquid cash available for your emergency fund.

[hogtied]

You are further ahead paying the penalty if you withdraw early for years 3-7, and near the same as a 2 year CD if you withdraw after 2 years than you would be with a CD ladder.  Check the chart.

[Reido]

I'm impressed - those yields are SIGNIFICANTLY better than anything I've seen offered by my local banks...  I'm a little wary of something that is so much better than what everyone else offers...

I think it's reasonable to put the "cash" section of your portfolio into something like that, as it seems that even if you withdrew it after 2-3  years (any of the CD's) and paid penalties you would still get a similar or even better return than what money-market accounts are paying.  You'd have a similar risk profile.

The Permanent Portfolio still handily beats these returns with low risk - the PP has inflation protection built in and it also yields roughly 9% per year.  I tend to think of it as beating inflation by 5% on average, rather than just yielding 9%.

[KevinW]

So if such an investor could find a 5 year CD that paid an equivalent rate of return, should that be a compelling alternative to the PP for those 5 years?

The problem with this reasoning is that it's impossible to know ahead of time what the PP's return will be over the next five, future years.

In particular, the PP does a good job of providing consistent real (after-inflation) returns.  A 5% CD provides 5% nominal (before-inflation) returns.  For the sake of argument, suppose the PP will return 4% over inflation.  The 5% CD looks good as long as inflation is 1% or less.  But if we have a period of 10%+ inflation, the PP will look a lot better than a CD stuck at 5% nominal return.

Buying a 5% CD amounts to speculating that interest rates will stay low over the next few years.  That may happen, or it may not.  So it's impossible to say whether that will turn out to be better than the PP over that time period.  Browne's advice was to use the variable portfolio for these kinds of speculations.

[ecuadj]

Hi All,

Thanks for the replies. Here are my comments/questions on some of the points raised so far:

* The rate of the CD I'm investigating is a little over 7%. It's not in USD, but it's in my "home" currency (AUD), so (I think) that means I'm not taking any abnormal currency risk.

* I apologize for using the word "zero" (and in all caps no less ) I agree that CDs have a non-zero risk of capital loss. What I was trying to say is that if you invest, say, $10k in gold, $10k in shares, and $10k in a CD, then on some random future date you probably wouldn't be surpised if you had less than $10k in gold or shares, but you probably would be if you had less than $10k in the CD!

* To investigate the comment that the PP "yields roughly 9% per year" I did some (very rough) mucking around with the numbers in craigr's historical returns page:

- When I took the simple average (no compounding) of the PP's annual return from year X until 2009, I found that it's only above 9% for X in the 1970s. If X is any of the 30 years from 1980 onwards, then it's below 9% (because the spectacular PP year of 1979 is excluded). Furthermore, starting in 18 of those 30 years, the average return to date is less than 8%.

- Simba's spreadsheet also has a tab where you can do this sort of thing for every year from 1985 onwards. There, the PP does better than an average of 8% only if you start in 2002, 2003, or 2005. It's lower than 8% starting in every other year, and lower than 7% starting in 8 of them, including the entire half-decade 1996-2000.

- So I guess my conclusion is that a guaranteed 5% vs a rock-solid 9% is not very interesting, but a guaranteed 7% vs a less-solid 6-8% is moreso (at least to me )

* I have some questions about the comments that "the PP has inflation protection built in" and that "the PP does a good job of providing consistent real (after-inflation) returns". I'm pretty clueless about inflation, so the following are genuinely ignorant questions rather than anything else they might appear to be: Why is it that we can make "inflation-resistant" claims like this? Is it solely because of the 25% gold component? If so, does that mean that a portfolio with, say, 10% gold could make a like claim? Similarly, does that mean that portfolios without gold can't claim to be inflation-resistant or to deliver returns that are inflation + X%?

* Finally, I just wanted to reiterate that the idea is not that the CD will definitely (or even probably) beat the PP over the next 5 years. I'm just speaking as someone who has been attracted to the PP philosophy because it offers the combination of a sufficiently low chance of capital reduction combined with a sufficiently high (but unspectacular) historic rate of return. And I'm exploring the idea that once CD rates get to a certain level (and 7% may well not be high enough) then they too seem to offer this combination. Or does the spectre of inflation mean that this will never be the case?

Thanks again!

[Pkg Man]

It certainly does depend on what time frame one is looking at.  If you begin in 2000, stocks have been a terrible investment, even cash has performed better.  By looking at it strictly from that perspective during this particular time frame, in retrospect it would have been best to have been 100% in gold.  But no serious person would invest that way. 

Although I like to gamble, I am not willing to flip a coin with my co-worker for our paychecks.  In the same vein I am not willing to place all my retirement savings on stocks as the best performing asset over the next 10 years.  Looking at long term historical average returns does not really provide much insight into how a particular asset will perform during a given period in the future.  One could look at Shiller's data on measuring how over or under "valued" the market is, but even that may not perform as indicated going forward.  But I agree that less risk averse folks will find the PP less appealing. 

As far as inflation, gold has been a very good hedge.  If my investments were limited to short term cash and gold, I would not recommend a 25% allocation to gold, but I think that some amount would still be in order.  While I am a fan of some international diversification (in the VP), I would be careful about investing a large portion of my savings in the currency of a country in which I don't live.

[Reido]

Hi ecuadj,

I was mistaken to assume that you meant a CD in the U.S.   I can't claim to be familiar with the relative risks associated with a CD in Australia.  So my observations may or may not apply.  Either way, here's my thinking on the issue -

I stated that the portfolio "averaged" 9% - that was clearly too vague of a statement.  I should have explained that the return tends to be close to 4.5-5% after inflation.

I'm getting my information from the same spreadsheet using 25%gold/25%LTGB/25%2-year treas./25%TSM.  I think this is a good representation of the PP.

Take the time periods 1972 and 1985 until present - the portfolio yielded 9.53% from '72 and 8.26% from '85
Still, this translates to a Real inflation adjusted gain of 4.85% from '72 and 5.19% from 1985.
Despite the lower number, the return has actually improved.

It's extremely important to note that from the early 80's to 2000 was probably the greatest bull market that has ever been seen, so any data from 1985-2009 will be heavily skewed towards stocks having high gains, even despite the last 10 years of poor performance - one great example is as follows:

A portfolio of 50%TSM and 50% total bond fund from 1985 to 2009 yields 9.29% but that's 6.18% above inflation.  If you drag it back to 1972 - before the bull market, it still yields 9.18% but that's now 4.52% above inflation.

Currently the S+P is actually down ~15% for the last 10 years, whereas the PP yielded 7.17% - again 4.5% above inflation.

We can find a period where a 7% 10yr CD would have done poorly - 1972-1982 had inflation rates averaging 8.59% - you would have lost 1.59% per year in the CD - still, the PP averaged 13.69% largely due to gains in Gold over that time period - an average gain of 23% per year!

Over the same period: TSM: averaged 8.06% but lost slightly to inflation
Total Bond: averaged 7.87% but lost to inflation as well

My point is that you could do VERY well with the 7%CD - in fact I'd be very tempted to take that myself!!  But you could also lose out - the PP is likely to buffer you from inflation.

Ultimately, I can't claim to be familiar with where you are, and certainly not with the likelihood of having inflation be that high.  But from what I've seen - there exists the possibility that you could see inflation like that...  It has happened.

I do realize that for as often as the gold saves the portfolio - it also drags it down...  but the consistency certainly appears to be there overall.

Hope this helps...

[Reido]

I just had a free moment at work (and since I lack any semblance of an interesting life) -

I calculated out all the 5yr periods for the permanent portfolio from 1972 to 2009.  1972-1976, 1973-1977, 1974-1978 and so on...

Using 2yr treasuries, gold, TSM, and LGTB: I found the lowest "REAL" return was 1.01% from 1980-1984 and the highest was 9.75% from 1982-1986

The average was 4.70%

Now that may or may not be a good representation of what you can expect from the portfolio, but it appears to be pretty consistent with longer periods of time too...

On a side note:    You asked about gold.

Again, I'm not an expert, but what I've noticed is that the portfolio is 25% devoted to gold; this seems to be a pretty reasonable percentage for a portfolio with other investments that are pretty volatile -
LGTB and TSM have a wide range of returns, so it seems appropriate to balance those against gold which also has a very volatile nature. 

If you had a less volatile portfolio, then TIPS may be appropriate - or certainly a lower percentage of gold.

[Reido]

Clive, thanks so much buddy - I knew there had to be an easier way!!!