25 yr old Interested in PP

[rhymenocerous]

Hello,

I've been saving/investing for about 2.5 years now and have managed to accumulate $80k on a $40k salary.  Up until now I've held a very simple portfolio of: 50% US Equity Index, 25% Intl Equity Index, 25% Total Bond Index.  The total expense ratio is around 0.12%.  After reading through this site, I've become very interested in how you can combine four very different asset classes to get such stable returns, possibly more so than the traditional stock/bond split.  One thing I do understand is that higher volatility of the overall portfolio leads to a lower CAGR than one that is more stable.  Perhaps I shouldn't think in terms of right and wrong, but what is the mistake I'm making by only investing in stocks/bonds that the PP corrects?  In what market conditions am I vulnerable?

The problem I see is that I'm not really aiming for preservation of capital alone, but feel I need to rely on stock returns over the next 40 years to reach my retirement goals.  Is it advisable to use the four asset classes, but in different percentages to get more exposure to equity?  I was thinking something like:

15% Long-term Treasury
10% Cash
15% Gold
20% Intl Equity
40% US Equity

or

25% Long-term Treasury
10% Cash
15% Gold
15% Intl Equity
35% US Equity

This kind of maintains my current 75/25 stock/bond split, but uses the four asset classes to hopefully provide similar, albeit slightly lower returns, but with much less volatility.  Does my thinking make sense?  Thanks for your help.

[MediumTex]

Welcome to the site.

I will let others speak to your proposed modifications to the PP, but the following comment jumped out at me and I would like to comment on it:

Perhaps I shouldn't think in terms of right and wrong, but what is the mistake I'm making by only investing in stocks/bonds that the PP corrects?  In what market conditions am I vulnerable?

I believe the mistake you are making by only investing in stocks and bonds is failing to realize that throughout history there are occasionally periods of time (some longer than others) during which promises among market participants are simply broken, including promises that no one thought could be broken. 

When you own stocks and bonds, all you own are a series of promises, and most of the time those promises may turn out reasonably well, but during the times when promise-breaking comes into vogue and everyone seems to be doing it (and there are many subtle methods of breaking promises), having an asset like gold to maintain balance in your portfolio is reassuring, and history shows that such an approach would allow an investor to weather virtually any storm the market might throw at him (including a storm of broken promises).

Don't underestimate the damage that broken promises from other market participants can have on your portfolio, whether these market participants are regulators, central bankers, accountants, CEOs or politicians.

[moda0306]

Most on this site would tell you that you should mentally and operationally separate the PP from a more aggressive portfolio, and while I can appreciate that method, I am one who finds that very difficult.

I think the more conservative of the two is an excellent portfolio for long-term returns and stability, but I'd do a backtest and stomach check to make sure that you would have been able to stick with it month-by-month through the turmoil of 2008 and early 2009.

A few things:

1) I am a pessimistic deflationist.  I think we have a lot of obstacles to overcome, so I'm skeptical of stocks ability to deliver the long-term return that some more optimistic people do.  I do, though, acknowledge that stocks have more return built into their pricing, even though it's not guaranteed.  What most will disagree with me on is the deflation piece.  I like long-term treasuries, and despite some high commodity costs due to scarcity, think we'll see a general deflationary environment.  This view is hardly shared by everyone here.

2) You want to pre-decide on your rebalance bands, so you don't make excuses along the way of why to let it keep getting out of wack.  A more agressive portfolio should probably stick to 20% cushion balancing bands instead of the 40% indiciated by 15/35 that most people here use.

3) Your allocations are good with me, but they are a bit arbitrary (as is 4x25 in some ways).  Go in understanding that you'll constantly be doubting an aggressive allocation... probably precisely at the worst time to be doubting it.  MediumTex has some great posts on the mental aspects of aggressive, volatile portfolios vs the PP.  Just try your best to understand your own mind and your own tolerance to volatility.  You probably didn't have much in the market in 2008, and neither did I, so I looked at the whole thing with kind of a "oh cool, let's see if the dow drops 700 points again today" type of attitude.  I think we both would have had a much different attitude had we had $200,000+ invested, and with 50-60% of your portfolio in stocks, you should really search your soul to see if you'd have been able to take that ride.

LTT's only late in 2008 really skyrocketed.  There were some pretty tough days for even a pure 4x25 PP holder.

Nice job saving hard and fast by the way!

[AdamA]

Perhaps I shouldn't think in terms of right and wrong, but what is the mistake I'm making by only investing in stocks/bonds that the PP corrects?  In what market conditions am I vulnerable?

Inflation can be scary when you hold a portfolio like this (stocks/bonds, no hard assets like gold). 

[Lone Wolf]

Welcome, rhymenocerous!  (I dig the Flight of the Conchords reference, by the way.)

First of all, fantastic job saving $80k in 2.5 years on a $40k salary.  Your savings rate has to be tremendous.  Saving that much at this young of an age already has you on the right path to your goals.  My hat's off.

Your portfolio as it stands today is most vulnerable to two conditions: inflation or strong deflation.

If we experience inflation (an expansion of the money supply that tends to cause rising prices), bonds will suffer.  As an example, if you own a bond that pays you 5% per year when inflation is causing prices to rise at 10% per year, you are effectively losing money on your bonds.  In addition, interest rates will tend to rise when inflation gets high, meaning that your bonds that pay a mere 5% will fall in value.  Generally speaking, when inflation is high, particularly if it is higher than the prevailing interest rate, gold will do very well.  Stocks might do "okay" but overall tend to underperform when inflation gets high.

On the other hand, a deflation is a contraction of the money supply that tends to cause prices to fall.  Bonds and cash will do well in a modest deflation but stocks will usually do very badly.  As interest rates fall, existing bonds rise in value.  Your bond that pays 5% interest is worth more now that interest rates are at 2.5%.  However, if a deflation is strong enough, you face several risks.  First, debt can become difficult to service and companies may fail or otherwise default on their obligations.  As a bondholder, this means you take a big haircut.  An additional risk is that most corporate bonds are "callable", meaning that the company that issues them can essentially choose to pay off the balance off the bond to you and refinance with somebody else at a lower interest rate.  (This is very similar to refinancing your home mortgage.)  For this reason, the Permanent Portfolio holds U.S. long-term Treasury bonds, which have virtually no credit risk and do not carry call provisions.

As for your allocation, I might recommend splitting your savings into a Permanent Portfolio and a Variable Portfolio.  The PP can be the money that Browne called "money you can't afford to lose" and just work in the standard stocks \ bonds \ gold \ cash arrangement described in "Fail-Safe Investing".  If you've got any questions about that, we're always willing to help.

The remainder of your money can be invested in whatever way you think will maximize your returns in the Variable Portfolio.  As long as you follow Browne's guideline to never remove money from the PP to add to the VP, this should work just fine.  (Personally, I just go with the traditional PP for all of my money, but many do build a Variable Portfolio.)

[moda0306]

MT's post on gold is pretty brilliant.

Another prism at which to look at it is this... Even in a stock/bond mix, you're not really asking WHAT bonds... because a treasury bond and a junk bond perform about at similarly as pork belly futures and a Mickey Mantle baseball card.

When the rate of returns on stocks are questioned, the safest return assets tend to develop a larger spread from risky bonds and those stocks.  The instrument most likely to benefit from that increase in spread is a long-term treasury bond.  But since sometimes stocks are dropping due to unexpected inflation or currency problems, these aren't 100% reliable to move the way you'd want them to in a stock tumble (see 1970's).

Most financial advisors make up for this by shortening the duration of the bond so it can more likely keep up with rising interest rates, but those don't move as hard and fast as long-term bonds do in many instances.  Also, often shorter-term treasury instruments are yielding pathetic interest rates, so yield chasing becomes a weapon of choice, hence the use of munis or corporates.  The idea is that in most vanilla stock-drops, these relatively safe, relatively non-volatile instruments will hold pretty good ground when stocks drop 20%.  The problem is, it's the very same economic conditions that make stocks drop 40-50%+ that will call into question whether your corporate bonds are going to pay you.

Holding gold is a way to achieve the protection of LTT's without all the negatives of them possibly moving with stocks in an inflationary recession.

MT's description is way better, but this is just another way of looking at it in terms of why most coffeehouse portfolios use shorter-duration non-treasury bonds instead of how the PP thinks of it.

[moda0306]

LW's point about the "callability" of a bond is huge.  Like your eventual mortgage (if you'll even need one at the rate you're saving), most companies want to leave themselves an out in payment of a long-term bond.

This basically creates a "heads I win, tails you lose" scenario where you take on the risk of inflation and rising interest rates, without the benefits of deflation protection and that all-too-important price move that will help you offset your stock losses.

Think of owning corporate bonds as owning a potential junk bond.  But you took the liberty of buying it before the downgrade, and you also get to experience the downgrade as your stocks are also tanking.

Even muni's have very unattractive traits, and they are as revenue constrained as your local Wal-Mart in some ways.

[moda0306]

Further, as a big-saver, make sure you are properly using tax-deferral vehicles.  In your bracket, and if your healthy, I'd split between maxing out your Roth IRA and doing an HSA with a HDHP for health insurance.  If you still are socking money away, maybe try a Roth 401(k) if your job offers one.

Obviously you want to have a liquid cash cushion, but a roth allows you to withdraw tax/penalty-free what you've contributed, so you shouldn't scare yourself too much about liquidity... it's a nice option.

If you still find yourself with an un-welcome amount in taxable accounts, be sure to think of what order you are prioritizing your assets in.  An emergency fund and some gold coins should be in your taxable accounts, but after that any excess gold, cash or stocks (depending on interest rates... see link below), then long-term bonds, in that order, can also take up some taxable space.

http://gyroscopicinvesting.com/forum/in ... opic=770.0

Also, using the the following devices will help you beat/cheat taxes and the market (search this forum for these terms if you want to learn more):

- I bonds (as cash portion)
- Ally 5 year CD (as cash portion)
- Individual-security basis recognition method
- Loss-harvesting
- GTU (gold etf potentially taxed as capital gains)

[EM2]

Moda, what is "Individual-security basis recognition method?"

[moda0306]

You look at all of the purchases you made of, say, VTI since you started buying it.  If you've avoided rebalances by contributing to lagging assets, this could be a LONG time.  Normally, the default way of recognizing basis is a FIFO method (first-in-first-out) where your first share purchased is the first share you sold, and you recognize gain based on that price.

Another method is to individuall identify share purchases and consider those what made up the sale... So you pick your most expensive purchases and likely recognize very little gain.

I don't think you can do this method with gold, but I'm quite sure you can with bonds & stocks.

[EM2]

Got it, thanks.

[rhymenocerous]

Welcome to the site.

I will let others speak to your proposed modifications to the PP, but the following comment jumped out at me and I would like to comment on it:

Perhaps I shouldn't think in terms of right and wrong, but what is the mistake I'm making by only investing in stocks/bonds that the PP corrects?  In what market conditions am I vulnerable?

I believe the mistake you are making by only investing in stocks and bonds is failing to realize that throughout history there are occasionally periods of time (some longer than others) during which promises among market participants are simply broken, including promises that no one thought could be broken.  

When you own stocks and bonds, all you own are a series of promises, and most of the time those promises may turn out reasonably well, but during the times when promise-breaking comes into vogue and everyone seems to be doing it (and there are many subtle methods of breaking promises), having an asset like gold to maintain balance in your portfolio is reassuring, and history shows that such an approach would allow an investor to weather virtually any storm the market might throw at him (including a storm of broken promises).

Don't underestimate the damage that broken promises from other market participants can have on your portfolio, whether these market participants are regulators, central bankers, accountants, CEOs or politicians.

Sorry, perhaps I just lack the historical investment knowledge, but could you give a few specific examples of what you mean exactly?

[MediumTex]

Sorry, perhaps I just lack the historical investment knowledge, but could you give a few specific examples of what you mean exactly?

In general, and from a long term perspective:

Every failed government is a broken promise to its citizenry.

and

Every failed currency is a broken promise to people who saved their money.

***

Here are just a few broken promises from the last few years, but history is littered with them:

Early to Mid-1990s - Russia takes on debt promising to repay creditors.  1998 - Russia defaults on debt, resulting in huge losses to creditors and repercussions across world economy.

2001 - Executives at Enron promise shareholders that company is on sound footing.  Toward the end of the year it becomes clear that the company is going to completely collapse into the largest bankruptcy in history (as of that point in time), resulting in total loss to Enron shareholders (including many employees' life savings in their retirement accounts).

2008 - Bear Stearns promises shareholders and the public it is solvent and in no danger of collapse.  Later in 2008, Bear Stearns collapses, resulting in almost total loss to shareholders.  (Same story for Lehman Brothers later in the year).

2008 - Hank Paulson promises the American people that TARP is going to be used to take the bad assets off the banks' balance sheets and restore them to health.  To date, banks have engaged in no meaningful writedowns of asset values and are relying on accounting gimmicks to remain solvent.  

2008 - Candidate Obama promises to deliver "change."  As of today, after the worst financial crisis since the Great Depression I see almost no change of any kind.  If anything, many problems are worse now than in 2008.

2010 - Congress passes Dodd-Frank bill promising financial reform.  As of today, it's becoming clear that Dodd-Frank was DOA from a meaningful regulatory or reform perspective.

***

What you will find when surveying the history of broken promises in the public sphere are the following:

1. When times are good, promises are easy to make and easy to keep.

2. When times get hard, promises are still easy to make but harder to keep.

3. When faced with the prospect of having to admit failure and publicly break a promise, many people and/or instititutions will begin to cheat and try to find some way to prevent having to publicly break their promise.  This process normally only makes the final breaking of the promise worse than it would have been had it occurred at an earlier point in time.  

***

My point isn't to judge promise-breakers or suggest that it is possible to build a world where all promises are kept; rather, it is just important to understand the dynamics of promise-breaking and how to protect yourself as much as possible from the fallout when suddenly all of the promises on which a society is based seem be broken at more or less the same time.  

The permanent portfolio investment strategy takes as a given that the promises in the form of stocks, bonds and cash will at some point be broken.  The promise in the form of stocks is broken through executives who either lie about the company's condition or are simply incompetent (when too many executives do this the whole market declines); the promise in the form of bonds is broken through default on the underlying issues; and the promise in the form of cash is broken through devaluation and inflation.  Only gold is a promise that cannot be broken (viewed from this perspective, gold ETFs don't look like such a good idea).  

During times of prosperity gold as a protection against broken promises is not all that valuable--that's why gold didn't do well during the 1982-2000 period of prosperity (promises were relatively easy to keep during this period).  Since the secular bear market for stocks that began in 2000, and the housing bubble, financial crisis and everything else that followed, there is now a premium on promises that can't be broken, and I think this accounts for much of gold's price appreciation.

Note that I don't make these rules.  I am just observing them and summarizing them the best I can.

You may disagree with some of what I am saying, but I think that the basic premise is hard to argue with--a portfolio without gold is one that sooner or later will be hit with an event from which it will be unable to recover.  I think this is part of the reason that such large fortunes can disappear so quickly.  One change in government can wipe out generations of accumulated wealth.  One financial crisis can wipe out entire economies.  One bad period of inflation can wipe out many people's life savings.

Only gold provides even the possibility of cover for the individual investor during these events, and one thing that jumps out at you as you study history is that this sort of thing happens all the time.  It is rare for an entire lifetime to pass without a nation or economy experiencing at least some type of wealth-destroying event (and unfortunately people often have little advance warning of these events).  During most lifetimes several of these events occur.  In the U.S. we have been lucky to have had 60 years or so of relative stability, but there is no reason to believe that there are not events in the future that will resemble events from the past, including economic, financial and political upheavels that it makes sense to protect yourself against, even during the best of times (especially when it so easy to do through a strategy like the permanent portfolio).

All of this is just stuff I've picked up along the way.  Perhaps some of these ideas will help you to minimize future regret, which is normally one of the investor's primary goals.  The permament portfolio isn't the only game in town, but I would definitely look for something that works gold into the overall strategy.  Gold is a difficult asset to really understand, but once you "get" what it's about you normally see that no investment allocation can be complete without it.

[SmallPotatoes]

Free yourself from financial anxiety and choose the PP.

It's simple, cheap, and fail-safe.  The four components truly made an all-weather portfolio, and the most mysterious asset (gold) has kept my money safe in 2010. 

I think Medium said it best: you could do a lot worse than the PP. I would only add that you would be hard pressed and plain lucky to do better.

[Lone Wolf]

Gold is a difficult asset to really understand, but once you "get" what it's about you normally see that no investment allocation can be complete without it.

Completely agree.  Outstanding essay.

I'm a big-time optimist so it took me some time and study to understand gold's role in a properly diversified portfolio.  But I found that once I extended the time horizon over which I looked past just the last few decades, gold's role became much less mysterious to me.

[moda0306]

I guess there is a trifecta of "promises" within the volatile assets PP.  Once you see how they are very different in terms of the underlying fundamentals of the contracts, then you'll probably understand more what the purpose of gold

1) A promise to an unknown share of income of a company that could fail, return less than expected, etc.
  -Obviously, this is one of the riskier forms of nominal return
2) A promise to a fixed return for 30 years from an entity that almost cannot become insolvent... a borrower of last resort
  -This is on the other end of the "nominal return spectrum" of stocks.  A guaranteed payment over as long a period of time as possible.  This is paid out in a fiat currency, as are stock returns.
3) No promise at all... but a monetary metal that is an extremely valuable hedge against currency failure or debasement (a bond

These assets form something of a "promise trifecta"...  It probably will become more clear to you as you go that corporate and even muni bonds are too close to #1, and not even close to #2 in times when #1 type promises are being broken left and right.

Cash tends to perform as a cushion within the portfolio, with the benefit that it 1) will quickly "refinance" into prevailing interest rates to usually keep pace with inflation, and 2) never lose nominal value, and therefore never lose out to deflation.

All theories aside, see the 1970's through early 80's for a period of inflationary recession.  Bonds took a beating during this period, and gold, aided somewhat by having recently been price-controlled, saved the portfolio.

Some portfolio managers will argue that it takes much less gold than 25% of your portfolio to hedge against currency debasement or failure, and I'm sympathetic to this view, so that's part of the reason I like your allocation, but something about 4x25 DOES make you feel like you aren't playing "allocation picker" and probably leaves you much less likely to question yourself at what will probably be the worst time.  4x25 may be as arbitrary as anything else, but it doesn't really feel that way when the SHTF... it's like it's already been decided for you and you just are abiding by it.

[rhymenocerous]

Okay, so let me think about how to implement this in practice.  Current setup is:

401k- $16k Total Bond Index (has US Stock, Intl Stock, and Money Market available)
Roth IRA- $17k Total US Stock Index (can hold anything)
Taxable- $34k Total US Stock Index; Total Intl Stock Index (can hold anything)
Bank- $13k Cash

I currently contribute $16.5k per year to the 401k and $5k to the Roth.  However, I'm implementing a strategy whereby I use my bank/taxable account for expenses in order to transfer more money into the 401k.  Once the taxable money is used up hopefully I will be making enough money to contribute the full amount on my own, but currently I can only really afford to contribute about $10k per year if I didn't rely on the other accounts.  In the future, I think most of my savings will be in tax deferred accounts.

I would switch this to:

401k- Total US and Total Intl Stock Index
Roth IRA- Long Term Treasuries
Taxable- Gold, some US Stock, Short Term Treasuries
Bank- Cash/ CDs

I'm in the 15% tax bracket with a 5.3% state tax (MA).  What is the impact of holding gold (an ETF like IAU or GLD) in my taxable account?  Does anyone have any other suggestions for how to set this up?  Does anyone see a problem with future contributions, like my Roth not growing large enough to accommodate LTT and Gold?  With my 401k growing the fastest due to contributions, it seems like I'd end up overweighting stocks and/or cash.

[MediumTex]

Does your 401(k) plan have a "brokerage window" option?

You may have to ask this question several times and look several places.  It is typically a feature that not everyone knows about (and its use is typically not encouraged).

[rhymenocerous]

Does your 401(k) plan have a "brokerage window" option?

You may have to ask this question several times and look several places.  It is typically a feature that not everyone knows about (and its use is typically not encouraged).

I don't think so, but I'm not 100% sure.  The 401k is with Vanguard, and after looking on their website I don't see any kind of brokerage option.  I'd probably have to call and ask specifically though.

[MediumTex]

Does your 401(k) plan have a "brokerage window" option?

You may have to ask this question several times and look several places.  It is typically a feature that not everyone knows about (and its use is typically not encouraged).

I don't think so, but I'm not 100% sure.  The 401k is with Vanguard, and after looking on their website I don't see any kind of brokerage option.  I'd probably have to call and ask specifically though.

Ask for a copy of the plan's summary plan description.  It should be described there.  Vanguard is unlikely to have a complete answer.

[6 Iron]

I'm a big-time optimist...

Me too, and that is why my variable portfolio is less than 7 % of my invested assets, and getting smaller.  I have a knack for being biased by my hopes.

[rhymenocerous]

Thank you all for your help/advice.  I've listened to Craig's podcasts and they were especially informative.  I've decided to ease into this and go 50% PP and 50% Variable.  This is easiest for me since I only have to convert my bonds to equities in my 401k, and sell the equities in my Roth for Gold and LTT.  The setup will look like this:

Bank: $8.5k cash
Roth IRA: $8.5k IAU; $8.5k TLT
401k: $8.5k S&P 500

The taxable and the rest of the 401k would be split between US and Intl equity for the Variable portfolio.

Side note: what's the difference between using EDV over TLT?  Why is EDV more volatile?  Would it make sense to hold a 50/50 combo of EDV and VUSTX since I'm already with Vanguard?  I'm probably being penny-wise pound foolish in trying to avoid that $7 commission for TLT lol!  I do hate paying fees though.

[AdamA]

Side note: what's the difference between using EDV over TLT?  Why is EDV more volatile? 

EDV holds zero coupon bonds.  This means you don't get any of the interest payments until the bond matures.  This introduces what is known as reinvestment risk into your portfolio. 

ie, the 30 year LTT's pay you interest every six months, so you can reinvest this money should interest rates go up.  Zeros don't do this, so if interest rates go up, you're stuck with the bond, and it's not giving you any cash to reinvest at a higher rate.  For this reason, they are very sensitive to changes in interest rates.

Would it make sense to hold a 50/50 combo of EDV and VUSTX since I'm already with Vanguard?  I'm probably being penny-wise pound foolish in trying to avoid that $7 commission for TLT lol!  .

I think some people do this, but I'm not sure how much it changes the makeup of the portfolio.  Curious to hear what people say. 

For the sake of simplicity, I personally use TLT.

[Lone Wolf]

Side note: what's the difference between using EDV over TLT?  Why is EDV more volatile?  Would it make sense to hold a 50/50 combo of EDV and VUSTX since I'm already with Vanguard?  I'm probably being penny-wise pound foolish in trying to avoid that $7 commission for TLT lol!  I do hate paying fees though.

Personally I like simplicity so I'd just go for the TLT.  The idea of combining VUSTX and EDV is pretty clever but if avoiding a $7 is your motivation, I wouldn't worry about that.  Expense ratios matter more and Google thinks VUSTX's expense ratio is 0.22% and EDV is 0.14% versus 0.15% for TLT.

I am sure you will be fine either way, though.  Good luck!

[MediumTex]

I would use TLT to start with.

Over time, you may want to look into various PP "hacks", but I would just get started with a normal PP and get your mind started with the transition process from gambler (which is what most investors actually are) to investor (which is what the PP is all about).

It can be harder than it sounds to get used to a smooth ride after experiencing nothing but random bumpiness for a long time.