Troubled Waters Ahead for the PP

[WildAboutHarry]

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.

Yup.  Based on the Browne books that I have read.  Like I said, perhaps the idea arose/evolved in his newsletters, but I've not found a source for those.

A very simplified version of the evolution went something like this:

1974: Gold, Silver, Swiss Francs, other foreign currency
1977: Mix in some stocks
1978: Mix in home equity and real estate
1981: Mix in some long bonds
1987: Simplify to 4x25

That is why I think Harry backed into the macroeconomic condition explanation for the 4x25 version, rather than considering macroeconomic conditions and then fitting assets to them.

Regardless of how he got there, the 4x25 HBPP is a marvelous thing, and his writings are filled with pearls of wisdom.

[dualstow]

That is why I think Harry backed into the macroeconomic condition explanation for the 4x25 version, rather than considering macroeconomic conditions and then fitting assets to them.

Regardless of how he got there, the 4x25 HBPP is a marvelous thing, and his writings are filled with pearls of wisdom.

The way I thought of it, Harry did consider the macroeconomic conditions first and foremost, but then removed what was superfluous. For example, he removed silver, because he decided gold was doing the job. Maybe I'm wrong, but that's how I saw it.
If I were him, I would have put something in the name that stressed that there are only four assets. But, maybe "Permanent" is more important.

[RuralEngineer]

Honestly a PP "optimization" thread would be very interesting to me.  I do struggle a bit with the idea that 4 equal portions is the proper allocation because even if we turn off our TV, phone, cancel the newspaper, don't talk to anyone and then say "I now have no idea what the weather is going to be like tomorrow"...some weather is just more likely to occur than others.  It's a labored metaphor because weather is location and seasonally dependent, but my basic idea is that if we know, for example, that tight money recessions tend to be very brief, whereas prosperous inflation or stagflation can go on for decades, does it really make sense to allocate 25% of your portfolio for a deflationary environment when they tend to be brief?

[WildAboutHarry]

The way I thought of it, Harry did consider the macroeconomic conditions first and foremost, but then removed what was superfluous. For example, he removed silver, because he decided gold was doing the job. Maybe I'm wrong, but that's how I saw it.

If I were him, I would have put something in the name that stressed that there are only four assets. But, maybe "Permanent" is more important.

Early on, Harry talked about the "permanent" portfolio having a five to ten-year horizon.  Select the assets you think will allow a hands-off approach for money you cannot afford to lose and then leave it alone.  It was what was included under the "permanent" umbrella that changed over the years.

Harry came from a hard-asset perspective (read the 1975 Penthouse interview, for example), and then expanded and contracted his asset universe as conditions and his understanding changed.  He appears to be a prime candidate for a detailed biography (in addition to all the investment stuff he ran for president twice, for goodness sake).  Perhaps CraigR and MediumTex are already working on it?

[MachineGhost]

1978: Mix in home equity and real estate

Whatever happened to this?  As some here know, I actually consider the gold part to be a "Real Asset" allocation to broaden it out to other crisis-proof worthy assets, such as the above.

[blackomen]

I think there was a thread last year in which the question was asked, "What would make you abandon the pp?" And if I remember correctly, Medium Tex's answer was something like "3 consecutive years of (a loss)." I'm doing to adopt the same checkpoint. But, I've seen dramatic drops in equities and I keep going back like Rihanna.

I remember that thread too and I think he eventually qualified it to say it would have to be significant losses and also that there had to be a viable plan to replace it with. It's always possible it could be sinking like a rock for 3 years and still be the best plan available.

As for me, the one thing I can think of that would really shake my faith in the PP to the core would be if MT or Craig abandoned it.

If that day ever comes, I'm leveraging the PP..  (haha, j/k)

[MachineGhost]

Honestly a PP "optimization" thread would be very interesting to me.  I do struggle a bit with the idea that 4 equal portions is the proper allocation because even if we turn off our TV, phone, cancel the newspaper, don't talk to anyone and then say "I now have no idea what the weather is going to be like tomorrow"...some weather is just more likely to occur than others.  It's a labored metaphor because weather is location and seasonally dependent, but my basic idea is that if we know, for example, that tight money recessions tend to be very brief, whereas prosperous inflation or stagflation can go on for decades, does it really make sense to allocate 25% of your portfolio for a deflationary environment when they tend to be brief?

I have done many backtests of different strategic weightings, even point-in-time dynamic, and there are only minor differences between the core PP and some optimal solution.  It's just not worth worrying about.  If you can't handle the maximum drawdown of the Minksy Moment of 1929 or 1980, then increase the Wizard of Oz knob called Cash and decrease everything else proportionately.  But, I'll do you one better and give you the current optimal strategic weightings based on the severity and duration of each asset's maximum drawdown (back to 1975):

Stocks 2.9490%
Bonds 4.0737%
Gold .8140%
Cash 92.1633%

Somehow, I doubt you'll implement the above.  And in terms of risk parity, the leverage factors to normalize to bond risk:

Stocks 0.7239
Bonds 1.0000
Gold 0.1998
Cash 22.6237

So, I believe the real answer you are looking for has already been done by Bridgewater.  They monitor economic conditions and when things appear gnarly enough for Depression-era deflation, they will go into or ease into what they call the "Safe Portfolio" which is composed of hedged global nominal government bonds, hedged global government inflation-index bonds, government bills and gold.  So it seems that some kind of tactical allocation is the only way to completely minimize deflatonary risks.  Or, you could just turn that Wizard of Oz knob up...

I wish I knew about Bridgewater a few years ago.  It would have saved me a lot of mental anguish.

[JMoyle]

TennPaGa: I guess the only solution to our debt problem [that appears to be a big part of this economy otherwise why would the U.S. borrow for stimulus spending] is more debt! I suppose a monetary system built on borrowed money can only thrive on more borrowed money! Debt has become so mainstream that it is hard to rightfully distinguish productive debt from unproductive debt anymore. My only concerns regarding "troubled waters ahead for the PP" is that old Harry may not have contemplated our national debt growing so exponentially and affecting the economy with devaluation (housing prices), inflation (food and energy), recession (GDP and unemployment rates), and prosperity (stock market record highs) all at the same time! This economy kind of reminds me of the notion that giving a drunk with a hangover a drink makes the drunk feel better. Therefore, keep giving the drunk more drinks surely this is the solution to his immediate problem(s).

[MachineGhost]

After decades of study Ray, Bob, Greg Jensen, Dan Bernstein and  others  at  Bridgewater  created  an  investment  strategy structured  to  be  indifferent  to  shifts  in  discounted  economic conditions. Launched in 1996, All Weather was originally created for Ray’s trust assets. It is predicated on the notion that asset classes react in understandable ways based on the relationship of their cash flows to the economic environment. By balancing assets  based  on  these  structural  characteristics  the  impact of  economic  surprises  can  be  minimized. Market  participants might be surprised by inflation shifts or a growth bust and All Weather would chug along, providing attractive, relatively stable returns. The strategy was and is passive; in other words, this was the best portfolio Ray and his close associates could build without any  requirement  to  predict  future  conditions. Today  the  All Weather strategy and the concepts behind it are fundamentally changing  how  the  biggest  capital  pools  in  the  world  manage money. What began as a series of questions has blossomed into a movement. This article tells the story of how All Weather came into being. It recounts how a series of conversations hardened into principles that are the foundation of a coherent and practical investment philosophy.

http://www.bwater.com/Uploads/FileManag ... -Story.pdf

[rocketdog]

When discussing asset allocation it's easy to get enthralled with the hot performer (those stock portfolios are doing well so far this year). But if that asset turns against the investor they can get really clobbered. If an investor is OK with that risk, then they should just consider opening up a Variable Portfolio and putting more money into a broadly based index fund. There's nothing wrong with that if you are aware of the risks being taken.

That's essentially my approach.  In a nutshell, I'm building a PP with the same percentage of my portfolio as my age.  The balance is going into a VP, but not just any VP: I'm using a PP-like model in my VP too (except with little to no cash), with alternatives to the PP that are likely to perform similarly but also differently enough that I'm getting a bit more diversification.

For example, let's say I'm 40 (I'm not, but it makes the math easier).  My PP would be 10x4 which covers 40% of my investable funds, which is equal to my age. 

The other 60% would be my VP.  I would then split it evenly 3 ways (because I'm excluding cash) using essentially an "All-Weather Portfolio" approach:

20% = Equities, REITs, Corporate Credit.
20% = Nominal Bonds, Junk Bonds, TIPS.
20% = Commodities, Index-linked Bonds, Emerging Market Credit.

Then, rebalance annually, skimming 1% from the VP and using it to buy more PP holdings.  That way when I retire I'l be about 2/3 PP, 1/3 VP.  If that approach works in the years ahead, I'll stick with it.  If the PP persistently trumps my VP, then I'll probably accelerate the shift from VP to PP. 

[MachineGhost]

Here is a more layman explaination of the All Weather portfolio concept (PDF):

http://www.docyoushare.com/file/index.php?f=1QgKH7tp

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Note that with the implication of normalizing the risk, as opposed to the capital, cash becomes leveraged up and could be able to perform in a "tight money recession" during a "triple witch calamity" ala 1980-1981.  Essentially then, that may be the true weakness of the PP and not the witch.

[AgAuMoney]

I'm building a PP with the same percentage of my portfolio as my age.  The balance is going into a VP, but not just any VP: I'm using a PP-like model in my VP too (except with little to no cash), with alternatives to the PP that are likely to perform similarly but also differently enough that I'm getting a bit more diversification.

20% = Equities, REITs, Corporate Credit.
20% = Nominal Bonds, Junk Bonds, TIPS.
20% = Commodities, Index-linked Bonds, Emerging Market Credit.

Interesting.

I'm going the other direction - less and less PP as I accumulate more assets outside the PP.  I figure that as I have more and more income coming from outside the PP, I'll have less and less need for the PP, just like I'll have less and less need for other kinds of insurance.

Your three asset classes in your VP are interesting.  I'm doing equities and commodities right now, considering REITs but they make me leery. And everything else you mentioned is essentially bonds and in the current climate I want nothing to do with that.

[rocketdog]

I'm building a PP with the same percentage of my portfolio as my age.  The balance is going into a VP, but not just any VP: I'm using a PP-like model in my VP too (except with little to no cash), with alternatives to the PP that are likely to perform similarly but also differently enough that I'm getting a bit more diversification.

20% = Equities, REITs, Corporate Credit.
20% = Nominal Bonds, Junk Bonds, TIPS.
20% = Commodities, Index-linked Bonds, Emerging Market Credit.

Interesting.

I'm going the other direction - less and less PP as I accumulate more assets outside the PP.  I figure that as I have more and more income coming from outside the PP, I'll have less and less need for the PP, just like I'll have less and less need for other kinds of insurance.

Your three asset classes in your VP are interesting.  I'm doing equities and commodities right now, considering REITs but they make me leery. And everything else you mentioned is essentially bonds and in the current climate I want nothing to do with that.

I'm holding off on acquiring most of the bonds until interest rates start climbing back up (which I see as inevitable). 

As for increasing my PP over time, I view the PP as a relatively conservative approach, a "safe haven" of sorts.  So as I accumulate more and more retirement assets, I want to protect them as I get closer to retirement.  I don't want to be like the boomers who were heavily in equities and on the verge of retirement when the recession hit. 

Here's an analogy: imagine you're at a casino playing blackjack.  You know you're going to win some hands and lose some hands.  Each time you win, you put half your winnings in your pocket and put the other half back into your pool of gambling money.  Even if your pool eventually runs dry, you'll still have the money in your pocket.  In this analogy, your pocket is the PP and your pool is the VP.

[AgAuMoney]

As for increasing my PP over time, I view the PP as a relatively conservative approach, a "safe haven" of sorts.  So as I accumulate more and more retirement assets, I want to protect them as I get closer to retirement.  I don't want to be like the boomers who were heavily in equities and on the verge of retirement when the recession hit. 

Here's an analogy: imagine you're at a casino playing blackjack.  You know you're going to win some hands and lose some hands.  Each time you win, you put half your winnings in your pocket and put the other half back into your pool of gambling money.  Even if your pool eventually runs dry, you'll still have the money in your pocket.  In this analogy, your pocket is the PP and your pool is the VP.

Good analogy.  I agree that you need to keep something in reserve.  Always.  But the amount I need to keep in reserve is 100% when I'm first getting started in life.  I sure didn't put my first $1000 or even my first $5000 into the stock market!  But it is 100% only when first getting started.

As I accumulate assets the percentage needed in safe reserve declines and hopefully never again need be 100% of my assets.  I keep "enough" in reserve, and as long as I have "enough" in reserve, the rest of my assets can be used for other things.  Like visiting a casino.  Except if I take chances like that with my retirement, I'm going to be taking the house side, not the players...

For my analogy, imagine you own the casino and people keep paying to come and play.  As long as people keep paying to play, why do you care if the appraiser comes in and says your business is worth 2x what it was worth last year because tourism is up, or it is only worth 1/2 because convention bookings are down?  People keep paying to play, so why would you want to sell it off when you can just keep taking the income it generates just as you've been doing for years and years?

Real life, instead of owning a casino I own about 50 businesses that all pay me part of their income.  If I've owned these businesses on average more than 10 years and they have been paying me what I need to retire then I'm comfortable.  I don't care if the appraiser says they gained 100% or lost 50% as long as they keep paying me as they have historically paid me (even thru 2008, 2001, the 1970s and in some cases the 1930's.  Now if someone were to cut my take or not increase it the way I expect, we'll have words.  But other than that I let the managers run the businesses and I spend the money.

(OK, confession, I only own a minute fraction of each business, but never the less I am listed as an owner of each of those businesses.)

[rocketdog]

Real life, instead of owning a casino I own about 50 businesses that all pay me part of their income.  ... (OK, confession, I only own a minute fraction of each business, but never the less I am listed as an owner of each of those businesses.)

Nice -- I'll have to remember that at my next cocktail party:

"So, how do you invest your money?"

"I own businesses."

"Really? Which businesses do you own?"

"Oh, just about all of them."