Why Investors Should Fear The Permanent Portfolio

[doodle]

MT

Regarding your questions, I believe that my parents fear is based around two assets that are extremely volatile and have been in long secular bull markets.

No one knows when secular bull markets just turn into bubbles but when that happens and they pop people frequently will not regain their capital within their lifetime. The Nasdaq bubble is still at 50% down from where it was and the housing bubble deflation will probably take many years to regain former prices.

Because my parents are so close to retirement and returns are less important than pure preservation of capital I want to reduce the potential of getting caught in a bubble even if that means that I am taking the risk of tinkering with the PP.

Clive seems to have made a strong case for why the PP with a 5 year treasury ladder might provide similar returns going forward with less risk from rising rates. Because long term treasuries have been in such a long bull market and many intelligent investors are calling them the short of the century (jim rogers, warren buffet, bill gross) I don't feel comfortable with 25% of my parents retirement assets in them.

I view the other asset gold with a similar amount of precaution because it is practically at twice it all time high on a nominal basis. The difference between gold and LT treasuries is that gold has no upper price limit whereas LT treasuries do. Gold is also really the only true catastrophe insurance that my parents can buy. I told them that at this point they are looking at the possibility that the price of gold could be cut in half which would have a total effect of wiping out 5% of their total portfolio. They are comfortable with that risk considered what a crazy world we live in today.

The stock market has been in a bear market for a while now so I upped the percentage a little and split with international to add a little more diversity to avoid the potential impact of a Japanese like deflation experience in this country. I don't think this aspect of the portfolio is too strange.

Overall, I think given todays environment I feel more comfortable with this portfolio for them than the traditional PP. 

[Storm]

Clive's point is that the secular trend of declining rates added 2.14% to the PP returns.

Anyone disagree that this free lunch has ended?

So that's the new PP rate if interest rates stay constant, at any level.

Perhaps the free boost from secular bull market in long term treasuries has ended, but even in rising interest rate environments, the other components of the PP will do better.  Stocks and Gold in particular seem to outperform in periods of rising interest rates/inflation.

If inflation is in order, the gold component is more than capable of giving another 2.14% for the next 5 years.  If deflation is in order, the LTT component will continue to perform well.

I don't think we will end up in a scenario where inflation is something really high like 5-6% and the PP doesn't still give a real return of 3-4% above that.  In such an inflationary environment, our gold component would be rising 20% or more per year and giving you that real return that you need.

[MediumTex]

Overall, I think given todays environment I feel more comfortable with this portfolio for them than the traditional PP. 

Just remember what Harry Browne said--"when you break the package you lose the safety."

You may not see it this way now, but you are proposing a riskier strategy, not a safer one.

I have had my Mother's life savings in the PP for a little over two years.  Looking back, I am SO happy I didn't tinker with it based upon what I thought might happen next becauses I would have been wrong several times.

If you do go with your modified approach make sure you have predetermined rebalancing points.  Failing to rebalance in a mechanical way also adds significant risk to the portfolio.

If your modified approach doesn't provide good results, please reconsider the original non-tweaked PP.  I have seen more than one person start a tweaked PP and then not get the stable returns they were hoping for and abandon the whole strategy because it wasn't as safe and stable as they we expecting it to be.  In these cases, the person often doesn't consider that adopting the strategy as prescribed might have provided the safety and stability they sought.

Good luck with whatever you decide.

[stone]

Medium Tex, I've never been to Australia but I had heard that it was one of the few developed countries with above inflation short term rates. I did some googling and their consumer price inflation is currently 3% with short term rates of 5%. My impression of economic softness extending to Australia was based on having read:
"We are entering a period of fiscal austerity despite there being 12 per cent underutilised labour resources (sum of unemployment and underemployment) because the Government claims we are on the brink of an inflationary surge as a result of the so-called “once-in-a-hundred-year”? mining boom.
According to this narrative, business profits are high, business investment is high and growth will be rocketing ahead. Of-course the reality is somewhat different – not only has employment growth stalled but last week the National Accounts showed a staggeringly large contraction in the national economy."

[stone]

[quote="MediumTex"]
[quote="doodle"]
Just remember what Harry Browne said--"when you break the package you lose the safety."

I'm in the  position that my better half only really trusts cash so we have currently an 82% cash weighting (was 100%) with allocation to non-cash being on an add hoc basis whenever she considers it OK. She doesn't follow the markets or even watch the news so I think there is little danger of market based irrational exuberance driving the allocation. I'm happier with cash than I would be with any of the other single assets in isolation but I'm much happier with the PP than with 100% cash. What I've been doing is just keeping the "non-cash" equally as 50yearUKgovermentbonds, stocks and gold. I could potentially have instead just had the 18% "non-cash" as a classic 25:25:25:25 PP alongside the 82% cash but I hoped that so long as I was regularly expanding the "non-cash" portfolio at the expense of the "cash-portfolio" my level of tinkering wouldn't count as "breaking the package"???

[MediumTex]

Just remember what Harry Browne said--"when you break the package you lose the safety."

I'm in the  position that my better half only really trusts cash so we have currently an 82% cash weighting (was 100%) with allocation to non-cash being on an add hoc basis whenever she considers it OK. She doesn't follow the markets or even watch the news so I think there is little danger of market based irrational exuberance driving the allocation. I'm happier with cash than I would be with any of the other single assets in isolation but I'm much happier with the PP than with 100% cash. What I've been doing is just keeping the "non-cash" equally as 50yearUKgovermentbonds, stocks and gold. I could potentially have instead just had the 18% "non-cash" as a classic 25:25:25:25 PP alongside the 82% cash but I hoped that so long as I was regularly expanding the "non-cash" portfolio at the expense of the "cash-portfolio" my level of tinkering wouldn't count as "breaking the package"???

Everyone looks at the PP and sees something slightly different.  I just provide my own thoughts and comments about what I see when I look at the PP.

We all have different risk tolerances and investment objectives.  However, with cash paying basically 0%, I would think that most investors would find the safety and stability of the PP, along with its historical 9%+ returns to be an appealing alternative to cash at 0%.

I would say do what makes sense to you.

[doodle]

I really wish that Harry Browne was still alive to participate in this forum. I think he would have really enjoyed debating and analyzing these issues. It's sad that he had to go so young.

With regards to "breaking the PP guarantee" MT, I think that Clive's 5 year treasury model has a .996 correlation with the traditional PP across investment environments in the US and in other countries. Based on these studies I don't think that you can make the determination that the traditional PP is better.

Based on the environment that we are in currently I think a 5 year treasury would qualify as a safer investment where preservation of capital is the overriding interest.

If interest rates fall more and we get deflation I will benefit....but as I have argued deflation when you have a central bank who is wholy opposed to its existence would be a temporary event. I think the bigger danger in the next 10 years comes from rising, not falling rates.

If rates continue to fall the difference between a 30 year bond and 5 year bond yielding a few percentage points difference would make a little difference but either way the capital would be preserved.

If rates rise on the other hand the 5 year ladder would outperform whereas the traditional PP would experience a larger impact to capital.

[stone]

Medium Tex, what I was really asking was given that we "must" have two separate portfolios the much larger of which has 100% cash, is it still wise to add 25% cash in the stand alone LTT,stocks,gold portfolio so as to make it a genuine PP?

I like you, am convinced about the PP being preferable to being overweight in cash.

[Storm]

Medium Tex, what I was really asking was given that we "must" have two separate portfolios the much larger of which has 100% cash, is it still wise to add 25% cash in the stand alone LTT,stocks,gold portfolio so as to make it a genuine PP?

I like you, am convinced about the PP being preferable to being overweight in cash.

I would say if you are already so overweight in cash, you should just do a 33/33/33 split with the money you are allowed to invest.

[moda0306]

I think we get in this terminology of whether "rates" fall and it's kind of like saying what level "the river" is at.... which river are you talking about?

Short-term rates are 1) much more "manipulatable" by the fed, and due to the inherant stability of the underlying asset, are 2) naturally able to go lower in times of crisis when people want capital preservation and are willing to lose a bit to commodity inflation to have that.

But that doesn't explain the whole issue, as short-term treasury rates vs other bond instruments of the same duration are always shifting based on the health of the institutions that issue those bonds.

So you're left with this dynamic, fluid, bond yield curve and yield spreads.

Long-term bonds hold a very different role than capital preservation... I like to think of them as providing income preservation.  LT rates aren't that far off from where they've been most of the last decade... between 4 and 5 percent.  If "rates rise" in 2012, it could be as simple as short-term rates rising to make the yield-curve even again.

The nice thing about that is "rates rising" will bring the ST bonds into yielding more (finally) without an effect on the long-end of the curve.

If you invest in a 5-year bond at 1.48%, you might have more protected capital, but if "rates rise" it's likely that they could simply rise on the short end of the yield curve.... so you could see 5-years go to 4.2% from 1.48%, while 30-years STAY at 4.2%.

So the general media talks about "pathetically low bond rates," they're usually talking about the short end of the yield curve, and then they go on to say how "bonds suffer during rising interest rates" which is much more true of the long end of the curve (<1 yr bonds do JUST FINE during a period of rising rates, as long as those are positive real rates and not artificially pulled down).  So with two statements about bonds they've conveniently trashed them, even though each statement was talking about different durations of bonds, and of quality they don't care to mention.

I hate the term "rates" as it applies to the financial media almost as much as I hate the term "the market" (as in "What did the market do today?").  It allows the media to make a broad stroke that totally undermines the nuances of the market that need to be understood to give investing advice.

[Gumby]

With regards to "breaking the PP guarantee" MT, I think that Clive's 5 year treasury model has a .996 correlation with the traditional PP across investment environments in the US and in other countries. Based on these studies I don't think that you can make the determination that the traditional PP is better.

Forget past correlations. They don't mean anything unless we relive the exact same market conditions over and over again.

More importantly, aren't you throwing away your protection from deflation?? That's a pretty bold (and speculative) risk to take with your parents money. Especially since most crashes are deflationary. Clive is a wonderful and very talented market wizard, but I'm not sure he has fully explained all of the risks with his tweaked PP. If I remember correctly, Clive's protection from deflation is a series of stop-losses that need to be monitored very closely.

The future rarely turns out the way we expect it to. You may expect rising rates and find (like Bill Gross) that the exact opposite happens in reality.

I really wish that Harry Browne was still alive to participate in this forum.

Having listed to every single one of his investment radio shows, I can tell you that if Harry Browne was on this forum he'd be telling you that he would be very concerned with your tweaked PP — as he did with other callers. He would tell you that you don't have a crystal ball, and that you don't know for certain that we won't have deflation.

And if we did have a deflationary crash, then what would you do? You would not be protected.

You really ought to listen to his radio shows. They are truly a gift and I could not be more thankful that CraigR mirrored/archived them for us to listen to.

[MediumTex]

With regards to "breaking the PP guarantee" MT, I think that Clive's 5 year treasury model has a .996 correlation with the traditional PP across investment environments in the US and in other countries. Based on these studies I don't think that you can make the determination that the traditional PP is better.

Forget past correlations. They don't mean anything unless we relive the exact same market conditions over and over again.

Aren't you throwing away your protection from deflation?? That's a pretty bold risk to take with your parents money. Especially since most crashes are deflationary. Clive is a wonderful and very talented market wizard, but I'm not sure he has fully explained all of the risks with his tweaked method. If I remember correctly, Clive's protection from deflation is a series of stop-losses that need to be monitored very closely.

The future rarely turns out the way we expect it to. You may expect rising rates and find (like Bill Gross) that the exact opposite happens in reality.

I really wish that Harry Browne was still alive to participate in this forum.

Having listed to every single one of his investment radio shows, I can tell you that if Harry Browne was on this forum he'd be telling you that he would be very concerned with your tweaked PP — as he did with other callers. He would tell you that you don't have a crystal ball, and that you don't know for certain that we won't have deflation.

And if we did have a deflationary crash, then what would you do? You would not be protected.

You really ought to listen to his radio shows. They are truly a gift and I could not be more thankful that CraigR mirrored/archived them for us to listen to.

doodle, Gumby is saying the same thing I would say.

I respectfully suggest to you that there are gaps in your thinking that you are not currently seeing.  If you saw the gaps you would understand what we are saying to you.

We are not here to make market bets based upon our personal beliefs about what will happen next.  I personally think the stock market will trade sideways for another ten years, interest rates will drop and gold will continue grinding higher, but because I can't be sure I am right I buy the PP because it doesn't require me to be right.  It does, however, require me to acknowledge how profound my lack of knowledge about the future really is.

I am happy that you are posting your thoughts on this matter because I think it reveals what I might call the "architecture of PP objections", but since I believe this architecture is ultimately self-defeating (i.e., it won't take you where you really want to go), my hope is that I can help you see in your own thinking some of the gaps that I am seeing as I read what you are writing.

[Lone Wolf]

You really ought to listen to his radio shows. They are truly a gift and I could not be more thankful that CraigR mirrored/archived them for us to listen to.

I second this in the strongest possible terms.  They are excellent.

Some of the best bits are when someone calls into the show (in 2004-2005) predicting this or that circumstance and suggesting that the Permanent Portfolio may not adequately address it.  (An imminent collapse of the dollar was a popular one.)

Having said all that, of course only do what you are comfortable doing.  It's your (or your parents') money so the responsibility will ultimately rest with you.  My gut feel is that your tweaks won't make much difference one way or the other but I'd personally feel most comfortable with the full package of protection.

[stone]

Is a key reason why Clive's Japanese PP backtest is no better than the Japanese 1to5 year treasury ladder tweeked version precisely because real long term bonds are not available in Japan. If Japan had had 50year bonds as in the UK and the Japanese PP had used those rather than 10year bonds, then buying those in the 1980's would have totally saved the day and they would be worth a mint now. Japanese 10year bond yields at one point fell to 0.6%. Imagine buying a 50year bond now at 4.5% yield and then after 20years having the yield fall to 0.6%  giving enough capital gain to cope with just about any calamity with the other assets.

[cowboyhat]

Great discussion, and wonderful to see everyone being so polite.

The flip side of Clive's observation about the 5 year bond ladder = ST + LT bond combo is that you can hold 25% LT bonds if you hold 25% cash with no worries. If either way works from a financial perspective then maybe the question to ask yourself is which way makes you sleep better.

The good night's rest I get from holding a PP is a huge part of the value to me. For example, I've been watching the stock market's current belly ache with calm detachment. If there is a generalized liquidation of stocks, gold, and anything else that isn't nailed down, my TLT holding is going to shine. Even if the TLT counter-balance only matters for a few weeks, my lack anxiety during those few weeks is worth a lot of money to me.

I think the five year bond ladder makes sense if you can really ignore your PP when the front page of the newspaper is about the stock market. I don't have the guts for it.

[Bongleur]

>
But we've already been there and done that in the 1970s--we had a secular bear market for bonds and the PP had the same stable and steady returns as it had during the more recent secular bull market for bonds.
>

But gold behaved very differently in the 1970's than it can reasonably be expected to behave going forward.  Can you break down the PP yield in the 1970's into each of the 4 components?

[stone]

I was very struck by Clive's demonstration that for a Japanese PP backtest;  LTT would not have helped much beyond just having 50% STT. I just did some googling and 20year JGB have been available since the 1980's (40year JGB have only been available much more recently). The 20year JGB yield was 7% in 1990 and 0.8% in 2003. If the LTT part of the Japanese PP had been with such 20year JGB wouldn't that have amounted to a capital gain that dominated the PP? What am I missing?

[Bongleur]

I don't think we will end up in a scenario where inflation is something really high like 5-6%...  In such an inflationary environment, our gold component would be rising 20% or more per year...

http://inflationdata.com/inflation/Infl ... lation.asp

Gold is a "Crisis Hedge" not an  Inflation hedge

SNIP
But by the late 1970's the government had stopped its gold sales and the price took off.

Many felt that this rise was in response to inflation fears (and partly it was) as we will see in a moment inflation doesn't necessarily translate into higher gold prices. But fear of any sort usually does translate into higher gold prices.

From the peak in 1980 the inflation rate declined but cumulative inflation climbed steadily upward. But rather than keeping up with inflation the price of Gold fell from the peak of $850 per ounce down to under $300 in 2001.

But in inflation adjusted dollars the scene is even worse. The 1980 peak in current inflation adjusted dollars was over $2250 and it fell to under $370 losing a whopping 84% of its value!

So even though inflation rose... gold fell... because the fear level was low (and possibly because governments worldwide manipulated the price).

Inflation was slow and steady but not enough to cause fear. So Gold was not a very good inflation hedge!
SNIP

[stone]

Bolonguer "Gold is a "Crisis Hedge" not an  Inflation hedge"

Isn't gold price a mix of various themes. I read that emerging market local currency goverment bonds as an asset class show a close correlation to gold (as measured in USD or GBP terms) most of the time even though that asset class obviously is very negatively impacted by inflation in the countries issuing those bonds and could be exposed to crises. Your own currency devaluing; negative real interest rates (inflation adjusted) in any major global economy; affluence in India (where gold is consumed); fear in any large economy anywhere in the world; any central banks trying to devalue by buying gold and good old momentum herd mania all act together to support the gold price.

[stone]

Bolonguer, my impression as someone very new to all of this is that an absolutely key issue is that  lack of discernable deflation in the developed world is driven by an inflationary counter current from devaluation of developed world currencies relative to emerging market economies. That is just as supportive of gold and the PP as was the 1970's inflation. I also agree with all the other people on here who have been questioning this being a low point for bond yields.  Japanese 20 year government bond yields went down to 0.8%, that is a long way from the US and UK 4% currently being proclaimed as a crazy bubble. In inflation adjusted terms the UK yields do look extreme but money has to find a home somewhere. Pension funds etc can not have gold holdings and gold has its weirdnesses. High future returns for stocks are also a struggle for me to envisage. There are mountains of bank reserves beyond what are required for real economy liquidy. Those have zero return and that is the base support for total returns for the other asset options. In essence the current prices of all the asset classes represent a herd view. Saying that we are entering a secular bear market for this or that is basically saying that one has some insight above and beyond that herd view. I'm certain I have no such insight 

[Gumby]

I was very struck by Clive's demonstration that for a Japanese PP backtest;  LTT would not have helped much beyond just having 50% STT. I just did some googling and 20year JGB have been available since the 1980's (40year JGB have only been available much more recently). The 20year JGB yield was 7% in 1990 and 0.8% in 2003. If the LTT part of the Japanese PP had been with such 20year JGB wouldn't that have amounted to a capital gain that dominated the PP? What am I missing?

As brilliant as Clive is, the Japanese backtest is meaningless since it was impossible to construct a proper PP in Japan during the time that was backtested. Not only was it impossible to construct a proper PP, but it's impossible to imagine what a PP would have looked like if LTTs had been issued. Why?

Imagine trillions and trillions of Yen invested in 30 year bonds that were issued in 1980 at 11% or 12% or so. That means that in 1990 there would have been 20 year bonds at 11% or 12% on the secondary market — skewing competing borrowing rates and affecting other investments. And all that liquidity would have been pumped into the economy for another 20 years — contributing to inflation — offering more attractive safe options to investors all the while. Gold would have been different. Stocks would have been different. Bonds would have been different. And there would have been more Yen floating around to invest in all of those things as the bonds paid out.... 1985, 1990, 1995, 2000 all would have been very different in terms of where money was moving in and out of.

There's absolutely no way to compute the effect of a 30 year bond that never existed.

...and, in fact, we can't even compute what the 30 year rate, or 20 year rate, would have been in 1990 because the rates were skewed by the fact that no 30 year bond existed in 1980, 1975, 1970, and so on.

[MediumTex]

Clive,

Can you backtest a Japanese PP that consisted of the following:

50% Japanese 10 year bonds

25% gold

12.5% Nikkei equity index and 12.5% world equity index

***

The theme I am thinking of is basically a non-U.S. PP taking on more world equity exposure (I'm using 50% 10 year bonds to reflect the absence of 30 year bonds in Japan during some periods).  I just don't know how this would have actually worked out in practice.

[MediumTex]

Clive,

I don't recall the original Japanese PP results.  Are the results above better or worse?

[Bongleur]

Pension funds etc can not have gold holdings and gold has its weirdnesses.

There are mountains of bank reserves beyond what are required for real economy liquidy. Those have zero return

Pension funds are speculating in gold, and those reserves do earn interest paid by the Fed.

[doug6zj9]

The best therapy for those who are tempted to tinker with the formula is to set up the 4X25 with ETF's in nominal amounts or in hypothetical amounts, and watch it daily.  I have done this for 15 months, and this brings the concept to life.  You will quickly observe that it is often the 30 years that save the day, week, or month for you.  Talking about 30 year backtesting is meaningless, as it represents no meaningful timeline for any likely transaction.  If the 5 and the 30 test the same, then the more volatile 30 year is the better choice as the volatility you fear is what will bail you out in any relevant day, week, month, or year.  I think Harry has this right, and I was not a easy sell... It's a package.