Troubled Waters Ahead for the PP

[glennds]

Would you guys feel better if the PP was down 5% and S&P down 30% or PP up 5% and S&P up 30%?

I personally would feel much better about the former.

Good question. Neither scenario is necessarily bad, but I would certainly feel "better" about the former. This is because my objective for the PP is primarily as a capital preservation strategy. If I have to make a mutually exclusive choice, defending my assets in a hostile market is more important to me than chasing the hot dot.

Although the PP theory would suggest that it should capture a higher % of the uptick than this scenario.

[dualstow]

...
Somewhere, I read a study  comparing the happiness of two different groups of people: (1) Those with an income of around 75K/year living in a neighborhood where the mean income was 50k, and (2) individuals with an income of 100K a year, but living in a neighborhood with a mean income of 150K. Despite making 25K less, those living in the more modest neighborhood scored higher on their measure of happiness and satisfaction. Throw in a little schadenfreude, and it is not hard to see how people can make bad decisions with improper priorities. ...

Reminds me of that old joke in which the genie gives a man anything he asks for, but rewards his worst enemy with 2X the same wish.

[notsheigetz]

Seems somehow appropriate to this thread with a few drinks under my belt.  Scientists were expecting a "solar maximum" year but it seems awfully quiet. This has them worried because the sun is behaving in an unpredictable manner.

http://www.dailymail.co.uk/sciencetech/ ... cycle.html

[steve]

Putting things in perspective, the last time I rebalanced was more then 2 years ago and although year to date I am down just under 1%, My portfolio increased just under 21% from last re-balance. I came close to re balancing  but I never hit the 15/35 bands, I was close (33%) but I thought if I re balance early at least let it be 34%, now my portfolio has almost rebalanced it self without me touching it. What could be better up almost 21% and everything very close to perfect balance.

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[Grinners]

If any pillar of the portfolio falls to $0, then the entire portfolio falls to $0 with it.

Ie: hyperinflation, artificially created gold etc.

You would be selling your good assets to buy these as they lost value each and every day until you had nothing left.

That is when I would be out, but only then. Hopefully you would see it coming.

[AgAuMoney]

I think if stock market rallies are the toughest to stomach for people than they might want to consider a stock VP in a separate brokerage account. Although it is probably increasing your risk

Exactly.  This is why I am on the light side of my PP treasury allocation, and why I have a VP with stocks and silver.

I currently have roughly 40% PP and 60% VP.

I currently have roughly 47% stocks (mostly dividend growth), 29% gold and silver, 15% cash in various forms, and 9% EDV and TLT.

[MachineGhost]

Are you going to change your strategy?

I am going to increase my cash allocation and decrease the other three assets split proportionately.  The hit to the CAGR is minor, but the risk reduction is dramatic.  Ironically, more cash is exactly what would benefit in a "triple witching calamity" that would decimate the PP.  So I hope that the new maximum drawdown will only double from the previous figure set in 1980.  That's typically how it goes with out-of-sample performance in my experience.

I sure don't know if HB missed an economic environment.  But, I do think he may have vastly underestimated the sheer madness of crowds.  That may be its own economic environment defying all macroeconomic fundamentals that the PP is ill-equipped to deal with (or rather, the after effects).  But again, what is the alternative as so many say?  I see the solution being a permanent adjustment to the strategic weights, given all the variables both known and unknown.  That is the only way I can sleep at night.

In the meantime, I would feel a lot less scared if current market conditions presaging 1929, 1972, 1987, 2000, 2007 and 2011 were worked off before I direct a single penny more into stocks!

[WildAboutHarry]

Perhaps nitpicking, but the assets are not chosen because of their low correlation, but because of how they act in specific macroeconomic conditions.  The theory is that the 4 conditions driving the choice of assets covers every conceivable macro environment. 

I think the question here is, did Harry miss a possible macro environment?

If you think the answer is yes, please identify what it is.  In particular, how can stocks, gold, and long term treasuries all go down in a deflation?  If it's a deflation or even a global depression, wouldn't long term treasuries go up?

I am not really certain that I buy the argument that the 4x25 HBPP assets are chosen for "specific macroeconomic conditions."  Cash really isn't targeted to benefit from any macroeconomic condition, stocks do well in prosperous times but not awful in semi-prosperous times, gold does well in inflation except when it doesn't (and it does well when real interest rates are low, apparently regardless of the cause), long-term bonds do well in deflation but they do OK under mild inflation as well, etc.

Of the four economic conditions that Harry discusses, the "tight-money recession" seems to be the most contrived and of course the one that does not have any asset that "works" under those conditions.  I think the discussion of the asset classes under various economic conditions serves more as a general explanation of how the portfolio might work under those conditions rather than the fundamental basis for its operation/construction.  But I haven't read any Harry in a while, so I might go back for a look.

For me, the HBPP stands up better as a collection of asset classes with very low correlation that, when rebalanced, generate positive real returns under most economic conditions.

[JMoyle]

I find very interesting the postings in this thread of those who contemplate changing their investment direction to chase returns from an economy engineered to look like prosperity! What economy in the past has borrowed its way to prosperity? I wish I had an Investing Crystal Ball but I could not find one; but I believe I did find the next best thing in the PP Investing Strategy!

[dualstow]

Putting things in perspective, the last time I rebalanced was more then 2 years ago and although year to date I am down just under 1%, My portfolio increased just under 21% from last re-balance. I came close to re balancing  but I never hit the 15/35 bands, I was close (33%) but I thought if I re balance early at least let it be 34%, now my portfolio has almost rebalanced it self without me touching it. What could be better up almost 21% and everything very close to perfect balance.

Nice! I'm about to rebalance on Monday. First time!

[MediumTex]

I find very interesting the postings in this thread of those who contemplate changing their investment direction to chase returns from an economy engineered to look like prosperity! What economy in the past has borrowed its way to prosperity? I wish I had an Investing Crystal Ball but I could not find one; but I believe I did find the next best thing in the PP Investing Strategy!

The U.S. economy borrowed its way to prosperity throughout the 1980s and 1990s.

[JMoyle]

Medium Tex: is your point that the prosperity of the 80s and 90s bought on credit is to be viewed as a good thing? I am confused as to your point because I recall prosperity coming about in the 80s by a more favorable tax environment with pro-business and less government leadership affecting the economy coming out of the Carter years! In addition, I recall a post-cold war peace dividend, and the Republican Congress in the 90s trying to bring fiscal discipline [including social reforms] to the Federal budget creating projected budget surpluses with the intent of paying down the Federal debt taking us into the 2000s. But then... 9/11...Afghanistan/Iraq Actions ...un-funded Federal mandates like free prescription drugs attached to Medicare/Medicaid programs...mortgage loans to people who could not economically manage them...Obamacare (we have to pass it to see what is in it!)...Federal Reserve dropping interest rates to almost 0% enticing people to borrow more to purchase goods and causing retirees to put a lifetime of savings at risk in markets they normally would not be in with hopes to make enough money to pay bills in retirement! I hope you did not mean by your post that prosperity bought on credit is a good thing!

[rickb]

Perhaps nitpicking, but the assets are not chosen because of their low correlation, but because of how they act in specific macroeconomic conditions.  The theory is that the 4 conditions driving the choice of assets covers every conceivable macro environment. 

I think the question here is, did Harry miss a possible macro environment?

If you think the answer is yes, please identify what it is.  In particular, how can stocks, gold, and long term treasuries all go down in a deflation?  If it's a deflation or even a global depression, wouldn't long term treasuries go up?

I am not really certain that I buy the argument that the 4x25 HBPP assets are chosen for "specific macroeconomic conditions."  Cash really isn't targeted to benefit from any macroeconomic condition, stocks do well in prosperous times but not awful in semi-prosperous times, gold does well in inflation except when it doesn't (and it does well when real interest rates are low, apparently regardless of the cause), long-term bonds do well in deflation but they do OK under mild inflation as well, etc.

Of the four economic conditions that Harry discusses, the "tight-money recession" seems to be the most contrived and of course the one that does not have any asset that "works" under those conditions.  I think the discussion of the asset classes under various economic conditions serves more as a general explanation of how the portfolio might work under those conditions rather than the fundamental basis for its operation/construction.  But I haven't read any Harry in a while, so I might go back for a look.

For me, the HBPP stands up better as a collection of asset classes with very low correlation that, when rebalanced, generate positive real returns under most economic conditions.

Perhaps Craig or MT might want to comment here - my understanding (I think mostly from Browne's "Why the Best Laid Investment Plans Usually Go Wrong", but it's been a while since I read it - perhaps from discussions here as well) is that Browne looked back in history and divided it into macroeconomic climates, and then set out to find assets that would carry an overall portfolio in any of these economic conditions (i.e. it is the basis of the portfolio construction, and not an explanation applied after the fact).  Although this is completely different from looking back in history and finding assets that are uncorrelated with each tending to increase over time, both approaches probably end up in approximately the same place.  My impression is the latter approach (with a heavy dollop of MPT) is what Ray Dalio's (Bridgewater) All Weather Fund does - and they don't really care what the assets are or why they're uncorrelated, they only care about their correlations. 

And, yes, "tight money recession" (all out depression takes this to an extreme) seems contrived - and cash doesn't react in a way that protects the rest of the portfolio.  The problem seems to be that there isn't anything that can really protect you against this except holding a large amount of cash (which doesn't go up, but at least it doesn't go down).  I think Browne was aware of this, and simply couldn't find an asset with better attributes (the requirements are: goes up over the long term, and goes up sharply during this economic condition). 

I think the bottom line is that if you want protection against a depression, you have to give up most of your upside return.  For example, Bridgewater has a "Safe Portfolio" that would have held up during the 1929-1933 depression (see http://sdcera.granicus.com/MetaViewer.p ... ta_id=9141).  However, it lops off most of your upside during "normal" times as well (return equal to, but no higher than, inflation).

[Pointedstick]

I see cash more as a hedge against interest rates rising, which theoretically happens during a "tight money recession." If interest rates only gently rise by 1% per year, your long bonds are still going to get clobbered, but your cash will do fine and throw off larger coupon payments/dividends.

[melveyr]

Although this is completely different from looking back in history and finding assets that are uncorrelated with each tending to increase over time, both approaches probably end up in approximately the same place.  My impression is the latter approach (with a heavy dollop of MPT) is what Ray Dalio's (Bridgewater) All Weather Fund does - and they don't really care what the assets are or why they're uncorrelated, they only care about their correlations. 

Ray Dalio is extremely critical of looking at correlation coefficients for driving portfolio construction. His logic and framework is largely identical to Browne's except he expresses it through more instruments, on a global basis, and he explicitly uses leverage rather than implicitly (the PP uses the implicit leverage embedded in a 30 year bond). Dalio is good.

[AgAuMoney]

What I've read from Dalio made it seem that he did not care to reason or explain "why", but was content to accept it "is" for now and be prepared to change in the future if the "is" changes.  Did I miss where he deployed more logic largely identical to Browne's?

As for leverage, at least the "leverage embedded in a 30 year bond" is limited to that individual bond (or fund if done that way).  Adding leverage can add returns.  In my opinion it also increases overall risk, especially in times of financial stress (e.g. 2008).

[melveyr]

What I've read from Dalio made it seem that he did not care to reason or explain "why", but was content to accept it "is" for now and be prepared to change in the future if the "is" changes.  Did I miss where he deployed more logic largely identical to Browne's?

As for leverage, at least the "leverage embedded in a 30 year bond" is limited to that individual bond (or fund if done that way).  Adding leverage can add returns.  In my opinion it also increases overall risk, especially in times of financial stress (e.g. 2008).

Dalio uses the framework of growth/recession and inflation/deflation. He then develops separate portfolios that do better in each one of the scenarios and puts them all together for the All Weather fund in a balanced fashion. This is basically what HB did except for the final formulation Browne just picked one asset for each scenario whereas Dalio uses multiple assets.

Yes the leverage embedded within the 30 year is safer, but you do have to pay up for that luxury of limited downside. Historically, explicitly levering up a 10 year (by borrowing close to the risk free rate) to the same duration as a 30 year bond provided higher returns. This of course is only feasible for an institution that can borrow at cheap rates such as Bridgewater. I think going for the embedded leverage in the 30 year makes more sense for the retail investor, but if I were an institutional investor I would probably make use of my size to lever up a 10 year. These are really minor differences, but it is interesting. The 30 year bond is a really interesting tool.

[WildAboutHarry]

my understanding (I think mostly from Browne's "Why the Best Laid Investment Plans Usually Go Wrong", but it's been a while since I read it - perhaps from discussions here as well) is that Browne looked back in history and divided it into macroeconomic climates, and then set out to find assets that would carry an overall portfolio in any of these economic conditions (i.e. it is the basis of the portfolio construction, and not an explanation applied after the fact). 

The first iteration I can find of the HBPP (circa 1977) did not have cash or long bonds.  Cash showed up in 1978, and long bonds in 1981.  Just looking at how Harry mixed and matched assets over time suggests to me that his approach to portfolio construction was more of an iterative process than a deliberate attempt to fit specific assets to specific economic conditions.

And I do not mean to take anything away from Harry's approach, however he arrived at his "final" PP.  His development from basically a hard asset guy to an advocate of an innovative diversified portfolio is a great example of intellectual discovery and growth.

[MachineGhost]

And I do not mean to take anything away from Harry's approach, however he arrived at his "final" PP.  His development from basically a hard asset guy to an advocate of an innovative diversified portfolio is a great example of intellectual discovery and growth.

Browne's intellectual discovery and growth appears to have coincided with when it was exactly the right time to invest in cash and long-term bonds.  Such would have required continual awareness of the environment and not being passive.  Obviously, the maximum drawdown Browne experience in 1980 must have informed him that cash alone was not enough.

But since Browne is dead now, should we all follow Dalio to continue the concept's growth iteration?  I have not paid any attention to Dalio, but now it seems most warranted.  Bragging rights are far less important vs necessary adaptability.

[rickb]

my understanding (I think mostly from Browne's "Why the Best Laid Investment Plans Usually Go Wrong", but it's been a while since I read it - perhaps from discussions here as well) is that Browne looked back in history and divided it into macroeconomic climates, and then set out to find assets that would carry an overall portfolio in any of these economic conditions (i.e. it is the basis of the portfolio construction, and not an explanation applied after the fact). 

The first iteration I can find of the HBPP (circa 1977) did not have cash or long bonds.  Cash showed up in 1978, and long bonds in 1981.  Just looking at how Harry mixed and matched assets over time suggests to me that his approach to portfolio construction was more of an iterative process than a deliberate attempt to fit specific assets to specific economic conditions.

And I do not mean to take anything away from Harry's approach, however he arrived at his "final" PP.  His development from basically a hard asset guy to an advocate of an innovative diversified portfolio is a great example of intellectual discovery and growth.

No disagreement that his thoughts evolved over time.  If you read "How You Can Profit From the Coming Devaluation" and then "You Can Profit from a Monetary Crisis" and then "Why the Best Laid Investment Plans Usually Go Wrong" you can see this evolution.  My guess is sometime after he wrote "Profit from a Crisis" (which lays out a number of portfolios optimized according to what you think might unfold in the future) he had an epiphany - specifically, that you can't predict what might happen in the future and you need to protect yourself against (and profit in, or at least not be devastated by) any economic condition, and to do this you need a portfolio that "works" in any macro economic condition (and to do this, you need to know all macro economic conditions that are possible). I think it is in this particular period that he looked back in history, divided time into specific economic conditions, and worked out what specific assets (each with a positive long term trend) reacted strongly positively in each macro environment.  He may have started with a naive "diversification is a good thing" approach, but I think he ultimately ended up transcending this with a "hold something that works in each potential environment" approach.

His thoughts continued to evolve - for example, he jettisoned silver from the mix.  This seems based less on its correlation characteristics than on the fact that it doesn't react as strongly during periods of inflation than gold (i.e. correlation is not the issue).

The end result is the end result, and we may never know exactly how he got there - but I strongly suspect the motivation was  "what works best in each possible macro environment" rather than "what set of assets are least correlated".

Re Dalio: Dalio may well be the real deal, but unlike Browne I don't think Dalio gives a shit about the common investor.  Bridgewater has something like a $10M minimum. 

[sophie]

MG, thanks for the pointer to Ray Dalio.  It does look like he tried to update the Permanent Portfolio by adding his own twist:  balancing risk rather than quantities.

Scott's Investments has a version of the Dalio portfolio that could be managed by an individual investor:
http://www.scottsinvestments.com/2013/0 ... folio-new/

A few observations:
1. 15% to emerging market bonds??  That's a bit scary.
2. The whole portfolio is very bond-heavy (2/3 total), with no cash.  It makes me wonder about credit risk among other things.
3. There's a world of assumptions in balancing risk.  You can only do that using back-testing, and projecting those results to the future.  It may be a very good guess, but in the end it's still only a guess.

I don't see anything here that would make me think the PP is outdated, but it's definitely worth looking at more closely.  Probably in a new thread...

[WildAboutHarry]

The end result is the end result, and we may never know exactly how he got there - but I strongly suspect the motivation was  "what works best in each possible macro environment" rather than "what set of assets are least correlated".

I suspect we are in "six of one, half a dozen of another", "chicken and egg", and "how many angels can dance on the head of a pin" territory

In Inflation-Proofing Your Investments in 1981, Harry and Terry (couldn't resist the alliteration) wrote:

[The Permanent Portfolio's] principal ingredients are the investments that you expect to perform best during the next five to ten years.  The logic of the Permanent Portfolio assumes that you will not respond to any changes in short-term investment prospects.

The key consideration will be a proper balance among several different investments.

And then six years later the 4x25 version appeared.  It would be interesting to see Harry's newsletters during that period to see if he elaborates on his thought processes.

His thoughts continued to evolve - for example, he jettisoned silver from the mix.  This seems based less on its correlation characteristics than on the fact that it doesn't react as strongly during periods of inflation than gold (i.e. correlation is not the issue).

Harry admitted that dumping silver was purely a marketing-timing call in Why the Best-Laid Investment Plans Usually Go Wrong.

[gonetowindsurf]

If we are truly going to experience a bull market, PP will lag. Not sure if that would spell trouble, but maybe similar to 2012 performance.

[MachineGhost]

And then six years later the 4x25 version appeared.  It would be interesting to see Harry's newsletters during that period to see if he elaborates on his thought processes.

Wow, are you saying the current incarnation did not appear until 1987?!!  That's a heck of a lot of backwards-looking hindsight that everyone is assuming was not in-sample.  So the PP is even more of a theoretical contstruct vs battle-tested than before.

Speaking of theoreticals, Markowitz did not eat his own cooking after attacking the allocation problem and designing a algorithym.  He was more scared about losing money than optimizing his risk/reward, so he put half his money in stocks and half in bonds. 

EDIT: Checking the publishing dates, it looks like Why the Best-Laid Plans was first published in...  drum roll...  October 1987.  Fortuitous timing!  If we assume an investor bought the book back then where the 25%x4 appears to have been formally laid out and the investor was so shell-shocked by Black Monday, that they immediately implemented the portfolio on Nov. 1, 1987, the result up to Feb 15, 2013 would have been: 7.06% CAR and -15.54% MaxDD.  So about 2% less CAR and about 2.5% less MaxDD vs in-sample.