Inflation - Public Enemy #1

[Clive]

...

[MachineGhost]

Generally such wider diversification involves more effort and costs, just to perhaps achieve similar apparent rewards for most of the time. Some might argue that simpler is better under such circumstances. Wider diversification may however at some point save the day at which time the real benefit of that higher effort/costs could mean the difference between an otherwise critical condition having been reduced down to just being a relatively small hiccup.

You nailed it.  The PP is a post-Boglehead, multi-strategy hedge fund.  Both Bogle and Browne should be heralded as visionaries.  Why stop at just domestic stocks, gold buillion and inflation-prone ST bonds?  As you touched upon, history is replete with many examples of where such investments were useless in protecting against inflation or catastrophobic events.

Ultimately, you are arguing against being a cult Brownehead.  In my experience, a false sense of security always occurs right before the next big portfolio crisis.  If markets are constantly adjusting and adapting, then preparing to fight the last war is the wrong approach.  The market is designed to screw as many people as possible, not enable everyone to get wealthy.

MG

[craigr]

The bottom line of what I am suggesting is that the PP might not be as safe-and-sound as you might believe. Committing 100% of life savings to the PP is questionable IMO and instead you should consider diversifying the risk more widely. I'm not suggesting that the FTM necessarily be another choice/holding, but its a good example of how you might diversify. It could be set to perhaps hold 70% in inflation bonds and 30% in growth type assets/holdings that the PP doesn't hold (foreign stocks perhaps).

I guess the point I always come back to is this: Nobody is guaranteeing the Permanent Portfolio is the best. Or even that it will not have a big loss. Or even that it will always perform well going forward. Nobody can say those things about any investment strategy.

But I do know that owning only stocks and bonds has proven to not be reliable in the past in terms of providing real returns in all environments. Many of those allocations have also experienced big losses. So I can chalk those models off as already having failed.

However saying that putting 100% of the money into the strategy is not diversified isn't exactly correct either. You're talking about an allocation that would have you 25% in thousands of stocks in the economy, 25% in cash from an issuer that can always pay you back, 25% in bonds that perform admirably in deflation, and 25% in gold which is currency independent. The portfolio has an incredibly high degree of diversification. It's a much higher standard of diversification than most portfolio allocations I see advocated.

[MediumTex]

There is also the matter of having to do something with your money.

Simply not investing isn't an option.  There is never any money on the sidelines.  There is only a continuous series of playing fields, and you must pick which combination of them you want to put your money on.

I also don't see that anything all that special has happened to the PP in recent years.  If anything, it was the 1970s that would have suggested that the PP was about to stop working when it saw much larger returns than it has seen in the decades since.

I think that when people see the word "Permanent" in the PP, they often don't consider what that really means.

Remember, the economy can only be expanding or contracting (i.e., prosperity or recession) and the price level can only be rising or falling (inflation or deflation).  If you have assets that will profit from every combination of those conditions, what would be the scenario where the overall strategy would stop working?

The question I always want to ask is if the PP is going to be losing at some point in the future, what's going to be winning?

[FarmerD]

I don't think Clive is really repudiating the PP.  Essentially he's saying to put 50% of your money in the PP and 50% in a VP.  Let's face it, most of us don't have 100% invested in the PP.  I've got about 70% PP and 30% VP (though I’m trying to boost my percentage in the PP).  Seems to me this discussion is really about what percentage of one’s portfolio should be in the PP. 

One concern with what Clive suggested is that he's concentrating on rising inflation.  If deflation occurs, I’d worry having only 12.5% of my assets in long term treasuries. 

[LonerMatt]

Clive, I don't really understand what the FTM divided by PP shows - the chart's perhaps a little beyond me.

Am I right in assuming (based on the content of your post) that the two strategies seem to be, relatively, negatively correlated, and in some ways balance each other out?

Or am I simplifying what's been discussed?

[Gosso]

Clive,

I noticed the same thing when I compared the Canadian PP with the US PP priced in CAD.  When you combine the two (or at least balance CAD with Gold/USD) then you get a lower standard deviation while maintaining the PP yield.  They are not negatively correlated, but they do help balance each other out.

But what you are suggesting is that instead of looking at only other countries PP's for diversification, that I should be looking at this FTM instead.

I know almost nothing about FTM.  How does it handle the four economic scenarios compared to the PP?  Is it more geared towards inflation protection?

[moda0306]

I think where Clive's thinking breaks from some of us is that where the PP might appear kind of boring and almost lazy, each of its assets are grounded in macroeconomic fundamentals in a modern fiat economy.

Clive's observations are wonderful, and add a great element to this board, but it's hard for us to think of fundamental macroeconomic reasons that Small-Cap Value and Emerging Market economies (aka, markets with a very poor track record of respecting private property) will provide us with better diversification going forward, and so we're relying on past performance much more than fundamental understanding of these "asset classes" to drive our decision to invest in these.

Clive could prove 100% correct in his assertion about the different asset classes he mentions, but for those of us who love how the PP fits like a puzzle piece into our understanding of macroeconomics in a fiat world, it's tough for us to make that plunge.  I will remain pretty confident in the PP as long as the Euro mess is still with us.  After that, there could be a giant sucking sound out of gold and treasuries that dings us a bit.

[Gosso]

I seem to recall that a US'er that held a CAD PP over 2008 would have had a nasty shock of something like a -25% down year IIRC. (Great for the other way around however (CAD investor holding USD PP)).

I believe you are correct, since a Canadian holding a US PP would have seen a +21% gain in 2008.  (please see CA PP post here: http://gyroscopicinvesting.com/forum/ht ... 7#msg29777)  It is impressive how the power of currency appreciation and depreciation can impact the value of your portfolio when dealing with assets outside of your local currency.

During the 1930's up to early 1950's for instance the Fed suppressed treasury yields and in a couple of those years inflation raged at something like 18% one year, 10% another whilst treasury's were yielding 2% or less. Had treasury inflation bonds been available and held, then the impact of those events would have been less than having held 50% in STT and LTT's as the PP does.

You start to lose me when you start talking about TIPS in the 1930's.  I think that it is impossible to model the performance of TIPS in an era before they existed.  How can one calculate the impact this would have had on other bonds and the entire stock market -- the whole system dynamic would have been different if TIPS existed back then.  It's kinda like creating a scenario where humans lived alongside the dinosaurs -- who knows what kind of schenanigans that would have created.

[MediumTex]

Clive,

I am assuming that those FTM returns are simulated since FTM consists, in part, of a TIPS allocation, right?

In other words, historically no one could have actually done what the chart is showing; we're just hoping that the relationships will hold up in the future.

[rickb]

I think where Clive's thinking breaks from some of us is that where the PP might appear kind of boring and almost lazy, each of its assets are grounded in macroeconomic fundamentals in a modern fiat economy.

Clive's observations are wonderful, and add a great element to this board, but it's hard for us to think of fundamental macroeconomic reasons that Small-Cap Value and Emerging Market economies (aka, markets with a very poor track record of respecting private property) will provide us with better diversification going forward, and so we're relying on past performance much more than fundamental understanding of these "asset classes" to drive our decision to invest in these.

Clive could prove 100% correct in his assertion about the different asset classes he mentions, but for those of us who love how the PP fits like a puzzle piece into our understanding of macroeconomics in a fiat world, it's tough for us to make that plunge.  I will remain pretty confident in the PP as long as the Euro mess is still with us.  After that, there could be a giant sucking sound out of gold and treasuries that dings us a bit.

Moda hits the nail on the head here.  A much more Harry Browne way to to internalize the insights Clive is providing is to tie everything back to the 4 fundamental market conditions.  SCV and EM do well in the same conditions other stocks do.  So, from a fundamental perspective, adding SCV and EM is simply diversifying the stock portion.  Perhaps instead of 25% total US stock market, an allocation of 15% US stock market, 5% SCV and 5% EM would add some diversification benefit (within the stock allocation).  Similarly, TIPS will (well, are supposed to) do well in periods of inflation, so perhaps reducing gold somewhat and adding TIPS might diversify within the gold allocation.  Medium term bonds don't act exactly like a ST/LT barbell, so reducing both the ST and LT and adding a 5-year ladder might be considered a diversification.

The end result is the same whether you consider this a 50/50 (or 60/40 or whatever) mix of a standard PP and another portfolio model composed of these additional assets, or a PP with additional diversification within its 4 major asset classes.  The "purist" view says that the traditional PP assets are in some sense optimal (nothing responds as strongly as LT bonds to deflation, etc.), so diversifying away from these asset classes is actually harmful.  The "more diversification is better" view says in return for the effort this entails you'll be somewhat safer and should get somewhat better long term results.

This is the slice and dice vs. total market argument.  My guess is there's a portfolio size where it might make sense to think about slicing and dicing within the 4 PP asset classes, but that it's way higher than nearly anyone here cares about (maybe $20M). 

[craigr]

There were a lot of things going on in history the past 100 years to make drawing conclusions very difficult. While we can look at the performance of assets in the 1930s-1950s for instance we must never forget that within those 20 years was a Great Depression and a major World War. The WWII markets for instance were very distorted due to conflict overseas and domestically as there were price and production controls along with rationing in place for the war effort. Even the bond markets would have been distorted due to the war effort and the repaying of massive debts once hostilities ceased.

[moda0306]

The inaccessability of Small-cap stocks to a broad stock market of peoples' 401(k) plans, etc, might have changed the required rate of return of those in years before E-Trading existed.

Just one thought.

Small caps of that time maybe were much like "emerging markets" in that there wasn't a readily trusted index that carried them to the degree that the S&P 500 or DOW had (not so much because of location).

Over time, the investing mechanism into small caps eventually gained its clout, and it's hard to imagine much more of a liquid market to small cap investestors than the one we have today.

Basically, we've so simply securitized ALL stocks, that we've put them on a different playing field on which they compete with Treasuries and other savings instruments.  I wonder how much we have to pontificate the effects of that on future relative performance.

[Gosso]

To somewhat reiterate what rickb said - for a US investor holding 70% cash, 30% Canadian stocks is no different to holding 30% stocks, 70% cash and 30% CAD/USD currency exposure.

A diverse range of foreign stocks is no different to also holding a diverse range of currencies, which might also reflect a gold like holding - assuming gold to be a form of global currency.

I agree with this, especially since most stock markets are now highly correlated and even more so during stress, ie 2008.  Do you have an opinion on what percentage a portfolio should be balanced between domestic vs foreign currency.  With a combo of PP and FTM that would give you a 25-30% foreign/gold content.  But I was thinking a 50/50 balance might make more sense, especially in a smaller country like Canada.  I dusted off my copies of A Random Walk Down Wall Street and Four Pillars of Investing, and they lean towards 15-40% foreign content.  Malkiel even has a graph on page 193 showing 24% is the sweet spot for reducing volatility for a US investor.

I remember one prominent investor on the Bogleheads Canada forum, suggest that we should only have 5% Canadian content since Canada represents only 5% of the world economy -- I thought that was crazy.

So back to FTM.  I'm not sure I get it.  Is it the result of back-testing magic, or is there a logical foundation for its construction.  I was reading this blog post on Bogleheads and it seemed like they were trying to create a PP, except minus the gold which I find really quite funny.  Maybe you could bullet point the advantages of FTM over the PP?

[lazyboy]

I don't know what Fat Tailed Minimisation means.  ???

[lazyboy]

Thank you, Clive. That's very helpful.

[rickb]

I'd disagree with rickb about only needing such diversification at $20M+ however. 50% exposure to any one single risk is a relatively high concentration even for more modest sized portfolio's. 50% exposure to fixed income treasury's (STT and LTT) should Fed yield suppression continue when inflation perhaps turns upwards could, as has previously occurred, result in 4% gains versus 26%+ inflation across a couple of years. 50% exposure to that is a 11% real loss of total fund value over a relatively short period of time. And there's little stopping that potentially being much worse. If that coincides with stocks and gold being flat (or worse - down) and some income also being withdrawn for living expenses ... and things could turn a little ugly.

If something can happen, sooner or later most likely it will actually happen. Which leaves you clutching at the hope of not-in-my-lifetime.

You're effectively positing a fifth economic condition - high inflation with Fed yield suppression - and suggesting that stocks and gold won't do well enough in this situation to make up for the artificially low interest rates of the ST and LT.  In a normal transition to high inflation, ST rates rise (with inflation) but LT bonds get clobbered.   In the Fed suppression scenario it seems like avoiding the principal decrease in LT could more than make up for the artificially low ST rates - i.e. someone holding a traditional PP might be better off in this scenario than in a "normal" transition to high inflation.  Even assuming this is a fifth economic condition, it's not at all obvious (at least not to me) that the standard PP wouldn't deal with it just fine.

On the other hand I agree that 50% exposure to a single risk is dangerous.  The risk that frightens me is currency collapse, specifically collapse of the US dollar.  And it's actually a 75% exposure since for a US PP the stocks are denominated in dollars.   But FTM doesn't address this either.  And diversifying among international stocks/bonds in all likelihood doesn't help since if the US dollar collapses, it probably takes every other fiat currency with it.  I think most of us are indeed hoping this doesn't happen in our lifetimes - but if it does the 25% allocation to gold will allow us to preserve something.  If you consider this risk to be more likely than exceedingly unlikely, perhaps you should consider increasing your allocation to gold.  I strongly suspect decreasing your allocation to gold to "diversify" into non-US stocks/bonds will have the opposite of the effect you desire in the face of a US currency collapse.

[LonerMatt]

Not so much negatively correlated LonerMatt, as just different (not highly correlated). But otherwise you're near enough spot on, but its not so much just balancing each other out (reducing overall volatility) but also potentially adding some value (better overall gains for less risk) as well.

Over the very long term, both PP and FTM might provide similar rewards for similar levels of risk (volatility). If the risks are similar but the rewards for one was higher than the other then you'd just invest in that higher rewarding asset alone. If both produce similar overall gains with similar volatility, but they zigzag differently over time (aren't highly correlated), then holding some of both is generally better.

Measuring the running gain for each of FTM and PP and then plotting the running division of one by the other provides an indicator of that zigzag type effect.  Going by eye on that chart I posed earlier, between 1972 and 1983 it looks like the PP produced around a 66% greater gain than the PP i.e. if FTM rose 100% (a figure I've just pulled out of thin air) and the PP rose 166% then FTM / PP = 100 / 166 = 0.6. i.e. generally it would have been better to have been in the PP over those years.

From 1983 up to 2005 the FTM / PP ratio rose, i.e. it would have been better to have been in FTM ( 1.3 / 0.66 ) = 2.16 or 116% better gain from FTM compared to PP.

From 2005 again it was the PP's turn to have been better, relatively gaining 1.3 / 1 approximately = 30% more than FTM.

Had you timed perfectly and held PP from 1972 to 1982, FTM from 1983 to 2005, PP from 2005 to present, then you'd have made 1.66 x 2.16 x 1.3 = 4.5 or 350% more than having held just the PP or FTM alone for the entire 1972 to current timeperiod. You'd have been pretty lucky/clever to time to such perfection however. More generally just holding 50-50 of each and rebalancing back to equal weightings captures some of those rewards as you reduce the one that has relatively pulled ahead (sell-high) to add to the one that is lagging (buy-low). For equal weightings and 30% band rebalance trigger points for instance, that's like seeing $50 invested in each, having one rise $15 (30%) to $65 and the other decline $15 down to $35, at which time you sell $15 of the leader to add to the laggard. Which is (or can be) somewhat like having held some assets (15% of total funds) that were perfectly timed to those zigzag motions.

In some respects the chart indicates that FTM was more stock like, whilst the PP was more gold like. If you flipped that chart i.e. PP / FTM instead of FTM / PP, then it would have generally followed similar motions to the price of gold. If you consider PP as 'gold' and FTM as 'stocks' then generally its better to hold (and periodically rebalance) some of both rather than all gold or all stock alone.

Thanks Clive, much appreciated, you've really given me a lot of food for thought!

[Gosso]

On the other hand I agree that 50% exposure to a single risk is dangerous.  The risk that frightens me is currency collapse, specifically collapse of the US dollar.  And it's actually a 75% exposure since for a US PP the stocks are denominated in dollars.   But FTM doesn't address this either.  And diversifying among international stocks/bonds in all likelihood doesn't help since if the US dollar collapses, it probably takes every other fiat currency with it.  I think most of us are indeed hoping this doesn't happen in our lifetimes - but if it does the 25% allocation to gold will allow us to preserve something.  If you consider this risk to be more likely than exceedingly unlikely, perhaps you should consider increasing your allocation to gold.  I strongly suspect decreasing your allocation to gold to "diversify" into non-US stocks/bonds will have the opposite of the effect you desire in the face of a US currency collapse.

What about the normal 'ebb and flow' of currencies in relation to one another?  For example the USD index has dropped from 120 in 2000 down to 80 in 2012, representing a 33% drop.  Now I agree that this is not visible in the returns of USD assets for a US investor, but as a Canadian if I held USD assets then I would have taken a ~38% hit in CAD over this time period.

Currency fluctuations are a powerful force, and I'm just trying to harness them as best I can.  This is one aspect of investing that bothers me, and  I don't recall the Boglehead people having a good solution, other than foreign content should be 15-40% of the portfolio.

I'll stick with 65% CAD and 35% Gold/Foreign for now since it back-tests well.  But in my mind back-testing only tells a part of the story.

[Lone Wolf]

The risk that frightens me is currency collapse, specifically collapse of the US dollar.  And it's actually a 75% exposure since for a US PP the stocks are denominated in dollars.

This may be cold comfort, but in most hyperinflations the stock markets of the victim countries have put in "mediocre" performance (not doing great but also managing not to fall to zero.)  At least with stocks you do have the advantage of owning "real stuff" at a time when currency is fast becoming worthless (and "real stuff" becoming correspondingly more precious.)

This thread includes a report from JP Morgan that talks about stocks in Weimar.

Having said all of that, hyperinflation is so horrific that gold is the only asset I'd really trust when the chips were down.  It would be the one doing the really heavy lifting for the rest of the portfolio.

[stone]

To me the realistic black swan is some other currency taking on the mantle that the USD adopted in 1981. ie a huge very trust-able currency with very high above inflation interest rates. Then gold, treasuries stocks and the USD (and GBP, euro and Yen etc etc) would all be dumped to buy that currency. Inflation would be very high in the US etc because the exchange rate would become ever more awful versus that new currency. Basically the new hypothetical currency would do to the USA, UK, Japan etc what the developed world did to the third world over the 1980s and 1990s but perhaps more dramatic because we have further to fall. We might become no more able to afford imports than any of the other 7B people on earth.

To me I don't see what will stop such a scenario if we offshore all technical expertise and industrial capacity such that we are unable to compete and provide for ourselves if need be. I'm not saying it is a likely scenario, I'm just saying maintaining domestic expertise and a balanced economy is the only way to ensure any such possible event would be avoided.

[stone]

gosso

Currency fluctuations are a powerful force, and I'm just trying to harness them as best I can.  This is one aspect of investing that bothers me, and  I don't recall the Boglehead people having a good solution, other than foreign content should be 15-40% of the portfolio.

Gold captures these really well. The UK and Australian PP were saved in 2008 by gold (not to mention the Iceland PP ). Gold was a loosing asset for the Japanese PP. That shows just how much the currency movements are captured by gold.

[Gosso]

gosso

Currency fluctuations are a powerful force, and I'm just trying to harness them as best I can.  This is one aspect of investing that bothers me, and  I don't recall the Boglehead people having a good solution, other than foreign content should be 15-40% of the portfolio.

Gold captures these really well. The UK and Australian PP were saved in 2008 by gold (not to mention the Iceland PP ). Gold was a loosing asset for the Japanese PP. That shows just how much the currency movements are captured by gold.

Don't get me wrong, I think gold is great and acts as a wonderful hedge against your local currency.  It also saved my Canadian bacon in 2008.  But I wonder if it is enough.  I'm sure that the Icelander would be much happier if he had an extra 10-25% in US assets.

My biggest concern is not a sudden market crisis, but rather a long drawn out depreciation or appreciation of the local currency.  Most Boglehead people say it will all balance out in the end, but that is based mainly on hope.

It's hard for me to wrap my brain around the enormous impact currency fluctuations have on the economy, cost of living and your investments.  I may play around with 100% Canadian PP vs 100% US PP (in CAD) vs 50/50 blend, and break it out over five year periods.  I'll post results in the '50/50 Option' thread, if I get around to it.

Although I have a feeling I'm just putting speed holes in the PP to make it go faster.

[Ad Orientem]

If I were looking for a way to beef up my inflation hedge, without drastically deviating from the PP concept, I think I would give serious consideration to adopting a PP using the same or a very similar asset allocation to that which PRPFX holds.

20% Gold
 5% Silver
15% Natural Resource and Real Estate Stocks
15% Growth Stocks
35% Cash and LTT
10% Swiss (or diversified foreign government) Bonds

This could be set up using mostly index funds and or ETFs.  Now this leaves one exposed IMHO to a deflationary crisis, though perhaps not to an unacceptable degree.  PRPFX lost 8% in 2008, which while under-performing an HBPP was not horrible compared to what the rest of the financial markets tended to do.  On the other hand I tend to think this is a more inflation oriented portfolio.

EDIT: And of course I should mention that one could always just buy shares of PRPFX and skip the minimally seven ETFs needed to replicate it and deal with the regular rebalancing.  The issue of Fees & Expenses are always there.  But I might swallow hard and just suck it up for convenience sake provided they did not rise above their current level.

[stone]

Gosso, to me the irony is that you are a Canadian and so quite possibly will be entirely untroubled by a slow gradual sliding of the USD from its global reserve currency perch. Canada will always have enough food and minerals for its own people won't it? It doesn't matter to Canada whether it sells commodities to China and India rather than to USA, Europe and Japan.