3 Risks Of The Permanent Portfolio
Oct. 08, 2020 8:32 PM
Summary
What's changed since the strategy was created.
Why 2020's great performance can't continue.
Three potential strategy improvements.
I want to like the permanent portfolio. It’s a simple low-cost strategy with an excellent track record. In a nutshell, the portfolio is an equal mix of four assets designed to perform in all economic environments.
Unfortunately, future performance is guaranteed to be lower due to the strategy’s construction.
This post explains what’s wrong with the permanent portfolio and proposes three solutions.
Treasury Bonds
This is the main part of the strategy that will behave differently in the future.
Harry Browne created the permanent portfolio in 1982 when 30-year Treasury bonds (TLT) yielded 11%. Since then, 30-year bonds have almost matched the performance of stocks – an incredible feat for an investment with zero credit risk.
But what will these bonds earn going forward? A bond’s current yield is an accurate predictor of its future return:
Source: Wall Street Journal
The 30-year Treasury bond now yields 1.6%, so that’s a fair estimate for what it will earn over the next few decades. This low yield comes saddled with high interest rate risk. For example, if a 30-year bond’s yield rose from 1.6% to 3.6% its price would fall 37%.
So what’s an investor to do if they want the safety of bonds, less interest rate risk, and some yield? That’s the question every retiree in 2020 is trying to answer. One option is an actively managed bond fund.
I’m a huge fan of passive stock ETFs. Their active counterparts rarely outperform passive funds over time, mainly because 1.3% of stocks are responsible for all stock market gains over the last three decades. It’s tough to pick the next AAPL or AMZN, and high fees of active stock funds make it an even harder mission.
But the bond world is different. Active bond managers tend to outperform passive bond indexes:
Source: GMO
Michael Mauboussin has a great piece on why this is the case. There are hundreds of active bond funds but only a few meet the below criteria for the permanent portfolio:
Low cost. Fund fees are the strongest predictor of performance and the rest of strategy is implemented with low cost funds.
Low to moderate interest rate risk. A fund with long-term bonds would carry similar rate risk as the original Treasury allocation.
Low to moderate credit risk. This part of the permanent portfolio is for periods of economic weakness. Something like high-yield corporate bonds (JNK) would fall in tandem with stocks in a recession.
Here’s a list of bond funds that meet those requirements. P.S. If you’re investing in a taxable account, consider muni bonds (MUB). Traditional bond funds generate interest that is taxed at high ordinary income rates.
Cash
Cash (BIL) is perfect for a short-term emergency fund but makes less sense for a long-term portfolio.
I wish investors in 2020 could sit in cash and earn a high risk-free return. But yields today are a shadow of what they were when the permanent portfolio was created in 1982. The Fed is also clear they’ll keep rates at zero for years:
Cash is a melting ice cube if short-term rates don’t compensate for inflation:
Treasury inflation-protected securities (TIPS) didn’t exist in 1982 and they’re a compelling alternative to the permanent portfolio’s original cash holding. The value of a TIPS bond adjusts higher with inflation and TIPS are guaranteed by the U.S. government. This post explains more about how they work.
Some readers might point out that this part of the permanent portfolio is designed for deflation. TIPS can protect against deflation too:
Source: Treasury Direct
I would use short-term TIPS (VTIP) since they’re closer in nature to the original permanent portfolio’s cash allocation.
Stocks
The original permanent portfolio called for a 25% allocation to U.S. stocks (VTI). For most of the time since 1982, this was exactly the right stock allocation since U.S. companies outperformed.
But is it reasonable for a permanent portfolio to only own stocks from one country? It would have been difficult to predict the rise or fall of any of the below markets:
Source: Credit Suisse
How to split exposure between U.S. and international stocks (VXUS) is a constant point of debate. There are 11,000 posts on the Bogleheads forum on this topic. To save you some reading time: nobody knows the best mix because nobody can predict the future.
One solution is to own a single globally diversified stock fund. Vanguard’s VT does this and its allocation mirrors the above chart.
Gold
Gold is a polarizing investment and I used to be partial to it. I rode the last gold bull market in 2010 and started a company with the profits. This was luck, not skill. Nowadays I’m neutral on gold. I don’t think it’s a holy grail nor do I think gold is an overpriced rock.
Unlike the rest of the permanent portfolio, I wouldn’t change the original 25% in gold. This part of the strategy is meant for periods of currency weakness, and few assets can hedge that risk like gold. I do think gold investors need to keep two things in mind.
First, gold’s inflation protection can take a long time to materialize. One ounce of gold buys a similar amount of goods that it did thousands of years ago. Investor time horizons are measured in decades, not centuries. Gold lost 80% after inflation from 1980 to 2000:
Second, gold is tethered to real interest rates. Gold doesn’t generate income so it’s sensitive to what other investments yield.
Which scenario do you think is better for gold: when banks offer a 5% return on cash net of inflation (like in 1982) or when yields are zero and inflation is 1% (like now)? This year’s drop in rates lowered the opportunity cost to owning gold:
If you buy physical gold, go for bullion from a dealer charging as little over the spot price as possible. If you buy gold ETFs, skip the popular GLD fund. It charges 0.40% and there are plenty of lower-fee funds.
Summary
The original permanent portfolio looks great in the rear-view mirror. When you see stellar returns you have to ask “What led to this performance?” The permanent portfolio was lucky because it concentrated stock investments in the U.S. and owned long-term bonds during a multi-decade collapse in rates. For investors following this strategy, this post introduced three adjustments to ensure a portfolio stays permanent regardless of what the future holds.
This article was written by
Movement Capital
4.96K Followers
Eversight Wealth is an independent flat fee investment advisor offering financial planning and investment management services. We help investors build low-cost diversified portfolios, create comprehensive financial plans, and save money with a flat annual fee. Formerly Movement Capital.
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Analyst’s Disclosure: I am/we are long VTI, VXUS, VTIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Disclosures for each graph: Inflation-Adjusted Drawdown of Cash: This shows the inflation-adjusted return of 3-month Treasury bills. Data via FRED:
https://fred.stlouisfed.org/graph/?g=wxuE. These are hypothetical results, are not an indicator of future results, and do not represent returns any investor actually earned. Gold Inflation-Adjusted Price: This shows the inflation-adjusted adjusted price of gold. Data via FRED:
https://fred.stlouisfed.org/graph/?g=wwfS. No trading fees or taxes are reflected. These are hypothetical results, are not an indicator of future results, and do not represent returns any investor actually earned. Gold and Real Interest Rates: This shows the nominal price of gold on the left y-axis and the inverted real 10-year yield on the right axis. Data via FRED:
https://fred.stlouisfed.org/graph/?g=wwhu. No trading fees or taxes are reflected. These are hypothetical results, are not an indicator of future results, and do not represent returns any investor actually earned. Movement Capital (MVMT Capital LLC) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Movement Capital is properly licensed or exempt from licensure. This article is solely for informational purposes. Investments involve risk and are not guaranteed. No advice may be rendered by Movement Capital unless a client agreement is in place.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
