Gyroscopic Investing

For those of you who enjoy reading my posts, below are excerpts from a discussion I had about the PP and PRPFX that started WAY back in the week before Lehman Brothers collapsed in the Fall of 2008.  I am calling the person I was talking with "All Purpose Expert", or "APE" for short.

I have underlined some of the really great comments in the exchange.

It's sort of interesting to see how much has changed since then.

***

9-5-2008

All Purpose Expert ("APE"): I have a problem with an investment being characterized as being nearly as safe as a CD but with better returns, citing consistency and steadiness.

This fund [PRPFX] is not as safe as a CD. It has relatively poor returns which are erratic and anything but steady.

Further, while I completely understand in great depth the ideas that Browne put into the permanent portfolio, he based a lot of his criteria on the basis of correlations and causations between various economic conditions and certain asset classes.

This was in the days before the boom and bust cycles, globalized economies, fiat currencies and the ability to buy and sell cheap baskets of investments including commodities with the push of a button. When Harry conceived of the idea of the PP, wealthy people ruled wall street and everyone else did what their advisers and brokers told them was a good idea, all based on well accepted principals of economics.

I'm afraid that those days are gone and the predictability of these cycle/asset correlations hasnt really existed for the last 25 years, as evidenced by the returns of the permanent portfolio.

Lots of asset classes tend to suck at the same time these days, its not unusual for sudden and inexplicable rushes into and out of asset classes, and its quite normal to see gold go up or down well out of lockstep with inflation.

As far as "throwing out" the results of a particular manager, thats not really going to wash. The PP is about as much like an index as a managed fund can be, with Brownes blueprint serving as the basis, regularly rebalanced. Theres a little leeway around equities selection but the rest of the portfolio is what it is.

Someone looking for capital preservation in the face of inflation and poor economic times, with a little something extra in the way of dividends and not a lot of tolerance for risk should buy TIPS or an inflation adjusted annuity. Even an annuity gives better returns than this old dog.

But dont take my word for it, take this quote from one of Harry Brownes friends who wrote this shortly after his death:

"But there's a downside: The fund's long-term performance is poor compared to stocks, or even junk bonds. Its average return of 6.38% [before taxes, soft costs and cost of selling shares] is only one percentage point higher than safe T-bills! During the roaring 1990s, the Permanent Portfolio Fund seemed "permanently" in a funk, rising only 1% a year while stocks were exploding at a 20%-30% annual rate."

As far as your final comment, I think I made that point already. I dont think the treasuries or swiss government bond pieces are going to step up and deliver double digit returns. The equities piece is too small and not valued to where its going to step up and be the hero.

So that kinda leaves the dollar losing half its current value and gold heading to 1500-2000. That'd pretty much mean the wheels fell off our economy and the gas tank blew up.

To wrap up my...uh...'diatribe', its a good idea to understand your investments and where the returns will come from, comprehend the risks, and don't just jump on to the current hot thing and expect that its going to just keep on going.

Got any problems with that?

***

ME: This is my first post here, and I am happy to see PRPFX being discussed.

I think APE is being too harsh with the PP.

A couple of things to consider:

1. Although PRPFX is similar to Harry Browne's recommended allocation, it is different from HB's 25/25/25/25 recommendation. Although it wouldn't appear that the difference would affect returns much, it does. When you compare the PRPFX returns with the permanent portfolio returns on HB's website, you see that they are the same some years, but significantly different in others. I think it is the light long bond weighting in PRPFX and the presence of the Swiss bonds that accounts for the difference.

2. PRPFX has lost money for very few investors. The opportunity to get a 15% return or better in some years without a similar risk of losing that amount in other years makes it appealing.

3. The recent cut in the fund expense to .95% will juice the returns a little going forward (I believe the expense was 1.11% prior to this year).

4. For someone who simply doesn't want to lose any of their money, this is a good fund.

5. For someone who wants a counterpoint to aggressive equity investments, this is a good fund. I feel more comfortable with speculative plays knowing that PRPFX is likely to maintain its value relatively well.

6. PRPFX has only performed poorly in times of low inflation. If you know this up front, it should not bother you too much. As I said above, it's sort of a counterpoint to more speculative investments which would benefit from periods of low inflation.

7. The fund is quite tax efficient. What makes anyone think it's not? Look at its dividend distribution amounts--about 1% or so a year. That's pretty efficient.

8. I'm not a gold bug, but I like gold as part of the PRPFX portfolio.

9. A fixed income fund doesn't help you much in a period of inflation. Thus, I don't think that comparing the fund to a fixed income fund is fair.

10. Where are the low returns since inception coming from? Here's what I've got from the PRPFX website:

1983 - 5.32%
1984 - (13.09%)
1985 - 11.98%
1986 - 13.42%
1987 - 12.94%
1988 - 1.10%
1989 - 6.20%
1990 - (4.01%)
1991 - 8.01%
1992 - 2.46%
1993 - 15.45%
1994 - (2.93)
1995 - 15.40%
1996 - 1.60%
1997 - 5.58%
1998 - 3.39%
1999 - 1.10%
2000 - 5.83%
2001 - 3.76%
2002 - 14.31%
2003 - 20.44%
2004 - 12.04%
2005 - 7.62%
2006 - 13.82%
2007 - 12.43%

Based upon those returns, I get an annual average return over 25 years of 6.97%. Considering that much of that 25 year period had low levels of inflation, I think that's pretty good for a fund tilted toward inflation protection.

Going forward, I think that there is reason to believe that inflation will be a bigger problem than in the past, based upon the level of U.S. debt and the likelihood that high energy costs are going to be with us for a while.

It's not for everyone, but I think it's a good fund and fills a niche that no other fund fills. I would, however, like very much to see a fund set up that literally tracked Harry Browne's 25/25/25/25 allocation and put it together with as much tax efficiency as possible.

One can, of course, just buy an S&P 500 fund, a Treasury money market, TLT and GLD and there you have it, but the income that three of these funds would throw off would make the arrangement very tax inefficient. If you are in an IRA it wouldn't matter, of course.

I'm interested in any more thoughts on PRPFX and Harry Browne's thinking in general. I'll post the returns from the 25/25/25/25 approach later for comparison purposes.

Continued...

9-5-2008

APE: I wouldn't have bothered, but you did mention me by name.

This fund is doing really well. Since I said I didn't think it was a good investment its set a record for worst 3 month performance since inception. Down more than 6.5%. I'm guessing it has around another 7-10% drop to go before doing absolutely nothing for 10-15 years. Yep, almost as safe as a CD only with better returns. Wait...what?

The problem with the delta in the return numbers is that the ones you've posted don't incorporate expenses, trading costs, taxes and the cost of selling the fund shares. You wouldnt really expect a fund company to give you the actual (lower) numbers, would you? The chart I attached to one of my posts above (#41) is also from the fund company, and includes all costs and taxes.

Did I mention that this fund is very tax inefficient? Did I also mention 'buy low, sell high' lately?

***

ME: To be fair, why would you include the cost of selling the fund's shares and the capital gains it might trigger if you are not selling it?

The returns I cited were simply the difference between the fund price on the first and last day of the year, plus dividend distributions.

APE, I understand that you don't like the fund, what I don't understand is why. Is it too conservative? Does it not meet it stated goals? Does it not provide an alternative to just bonds or equities?

How would a bond fund provide the same return in a period of inflation? How would a TIPS fund provide the same return in a period of deflation?

It's the only mutual fund that holds equities that has not had a negative return in any of the past 10 years. Check it out.

It's had a tough quarter, but haven't most equities had a tough quarter?

Does it surprise you that this fund's returns don't follow Harry Browne's 25/25/25/25 mix all that closely? It surprised me.

Tell me again why the fund is not tax efficient? It distributes the absolute minimum in dividends that it is required to. Isn't that the definition of tax efficiency? The figures you are referring to from the website show what your after-tax return would be if you sold your shares. If you're not selling your shares, that information is not relevant.

Generally, do you believe that gold has any place in a portfolio? If so, what percentage do you think is appropriate? If you think that no gold holdings of any kind are appropriate, how does one take advantage of the occasional excellent returns from the PM sector? These periods are not as rare as you suggest. Since going off the gold standard in 1971, there have been two long bull markets for gold--1971-1980 and 2001-present. Thus, out of the last 37 years, gold would have potentially been profitable in your portfolio for 18 of those years. In the 1970s bull market it went from $35 an ounce to $800 an ounce. In the current bull market it has gone from $300 an ounce to $1,000 an ounce.

I'm not a gold bug, I just see the value of having a little in my portfolio. PRPFX is 20% gold and 5% silver. That might be a little heavy, but I don't think it's crazy.

Continued...

9-6-2008

ME: I think that there is about equal risk of an ugly inflation scenario as there is an ugly deflation scenario, ala Japan.

For these reasons, I think you have to have gold exposure for inflation and long bond exposure for deflation. Of course, you want to have good equity exposure (energy services is my favorite) as well. Add some cash and you're back at Harry Browne's permanent portfolio.

There is an excellent discussion of the true "permanent portfolio" as conceived by Harry Browne over on the bogleheads forum (this portfolio averages over 9% when tested back to the early 1970s).

For those who are unfamiliar with Harry Browne's investment thinking, I suggest you check out "Fail Safe Investing" (available for download for about $10 from his website) or "Why the Best Laid Investment Plans Usually Go Wrong", which is out of print, but can be picked up used for almost nothing on Amazon. The latter book is a much more exhaustive discussion of the permanent portfolio strategy.

I am a big Harry Browne fan. I don't think it's different this time. Money moves around like a nervous locust swarm. The four asset classes of the permanent portfolio capture the gains from its movement in an elegant manner over time.

If "minimizing future regret" is one of your investment goals, the permanent portfolio strategy is an appealing option. As I mentioned above, however, the PRPFX fund does NOT really track Harry Browne's strategy that closely.

PRPFX is broken down as follows:

20% gold
5% silver
15% aggressive growth stocks
15% natural resource and real estate stocks
10% Swiss franc short term bonds
35% treasury instruments (of which about 20% are short term and about 15% long term)

As you can see, this portfolio is tilted more toward inflation protection than deflation protection, and it was the brainchild of Terry Coxon, a colleague of Harry Browne.

If I were putting together a similar fund, I would do it this way:

20% gold
25% 30 year treasuries
20% short term treasuries
20% energy (no majors, just independents and service companies)
15% S&P 500

The only future assumption on which this portfolio is based is that energy infrastructure will require a greater chunk of world wealth to maintain, and that fiat currencies will be more volatile than in the past. Other than that, I am assuming the future will be similar to the past (which is an assumption on which the permanent portfolio is based).

***

APE: Wow, so taxes and costs associated with ownership and sales of funds don't matter if you don't plan to sell? Then the investment has no value and any changes to the valuation don't matter either. How magnificent to measure only the benefits and none of the expenses of an investment!

I already well covered why I don't think this fund is a good investment: it lost money to inflation for 20-something years and then had a run-up only when gold and oil shot through the roof due to speculative pressures and are now headed back down. And so is the fund. Much further down. Its an expensive fund that has underperformed for most of its history, has not been positively or negatively correlated to inflation or deflation, has had a speculative run up, and is going to go down. Down, down, down.

Gold hasn't reacted as a positive or negative correlation to inflation in 28 years, so unless you're prepared to produce a chart showing data to the contrary, can we discontinue the 1930's mantras about gold and inflation? Any movements in gold are purely speculative.

As far as using the long bond against deflation, we haven't seen serious deflation in almost a hundred years, and at the current rates, they wouldn't be very helpful in that unlikely scenario. With the small spread between long and short bonds, they're a lousy investment. And you're going to get killed when rates rise, as they most certainly will.

"It" is different this time. "It" has been changing constantly and its going to change more.

As far as minimizing future regret, if you'll be happy with your investments losing money and then losing ground to inflation when you could have done better with TIPS, then you'll be free of regret with this fund.

In the meanwhile, it seems the proponents of these investments either have a poor grasp of how they work, their risk levels, and unreasonable expectations for their returns, or they express talking points about the investments that arent borne out with actual data.

Perhaps you can go back to the beginning of the thread, look at the charts, data and trends that I posted that show that most of the platitudes surrounding these investments aren't demonstrated in the real world, and produce some contrary data?

Maybe I'll change my mind.

Continued...

9-6-2008

APE wrote:Wow, so taxes and costs associated with ownership and sales of funds dont matter if you dont plan to sell? Then the investment has no value and any changes to the valuation dont matter either. How magnificent to measure only the benefits and none of the expenses of an investment!

ME: I think you misunderstood me. What I meant was that I would prefer to have this fund's 1% dividend and more capital gain than the typical 3-4% in dividends a less tax efficient fund would throw off annually. For someone who wants to own it for a long time in a taxable account, I view this as a plus.

APE wrote:I already well covered why I dont think this fund is a good investment: it lost money to inflation for 20-something years and then had a run-up only when gold and oil shot through the roof due to speculative pressures and are now headed back down. And so is the fund. Much further down. Its an expensive fund that has underperformed for most of its history, has not been positively or negatively correlated to inflation or deflation, has had a speculative run up, and is going to go down. Down, down, down.

ME: Oil shot through the roof. Gold followed it. Short term there has been speculative pressure on oil, but long term I think we will see a new floor around $100 per barrel, rather than $10 a barrel that we saw only a few years ago. Time will tell.

APE wrote:Gold hasnt reacted as a positive or negative correlation to inflation in 28 years, so unless you're prepared to produce a chart showing data to the contrary, can we discontinue the 1930's mantras about gold and inflation? Any movements in gold are purely speculative.

ME: What is your definition of "speculative"? If an asset goes up in value consistently for several years, I don't know why you wouldn't want to capture some of those gains.

APE wrote:As far as using the long bond against deflation, we havent seen serious deflation in almost a hundred years, and at the current rates, they wouldnt be very helpful in that unlikely scenario. With the small spread between long and short bonds, they're a lousy investment. And you're going to get killed when rates rise, as they most certainly will.

ME: I'm sure that the Japanese would have had similar disdain for a deflation argument 20 years ago when the Nikkei was at 35,000.

APE wrote:"It" is different this time. "It" has been changing constantly and its going to change more.

ME: Inflation or deflation and recession or expansion are the only options. It can't be different.

Interesting discussion, though.

Continued...

9-6-2008

APE: Google "price of gold adjusted for inflation." You'll see that its largely lost real value. It doesn't "go up in value consistently". It goes sideways and downwards consistently with very infrequent periods of speculative spikes, with very poor correlation to any economic data. I'm not going to have the "GOLLLLDD!" discussion again, its been done. The data doesnt support it as a useful asset class except in small amounts for speculative purposes.

We don't live in Japan and don't run our economy the same way.

Lastly, how various asset classes respond to the four economic conditions you mentioned are very different now than they were 50 or 100 years ago.

Continued...

9-6-2008

APE wrote:Google "price of gold adjusted for inflation. You'll see that its largely lost real value. It doesnt "go up in value consistently". It goes sideways and downwards consistently with very infrequent periods of speculative spikes, with very poor correlation to any economic data. I'm not going to have the "GOLLLLDD!" discussion again, its been done. The data doesnt support it as a useful asset class except in small amounts for speculative purposes.

ME: Let me be clear--I do not want to have the gold discussion either. I am well aware that gold is very volatile and can just as easily go up or down. The fact is, however, that gold was $35 an ounce in 1971 and it was $800 an ounce this morning. Not that great compared to some investments, but pretty good compared to others. You know enough about HB's thinking to understand how gold works in the PP strategy. HB's PP strategy is far more subtle than "GOLLLLDD!", however.

APE wrote:We don't live in Japan and dont run our economy the same way.

ME: In what way is our economy different from Japan's that precludes a long deflationary period in the U.S.?

If you included the decline in housing prices in the CPI, we would have a core rate right now of under 2%, which would mean that the long bond market is not nearly as irrational as some people believe.

I assume you are aware that it is not possible to escape deflationary forces simply by printing more money if you are in a serious and systemic credit contraction....sort of like right now.

APE wrote:Lastly, how various asset classes respond to the four economic conditions you mentioned are very different now than they were 50 or 100 years ago.

ME: What's different? Credit contraction is deflationary. Inflation expectations, easy credit and poor fiscal policy lead to inflation. High energy prices lead to recession and inflation. Economic growth leads to expansion. I'm really curious about why these forces are different today.

It's true that since the demise of the gold standard, there does appear to be a long term controlled devaluation of fiat currencies, but that's about the only fundamental difference I see in today's world compared to the past when it comes to investments. Can you elaborate more on how investing is different today? Hasn't it always been a matter of finding the most efficient places to deploy capital, finding the most creditworthy borrowers at a given interest rate, and finding reliable stores of value?

Far from a bubble, I think that the price action in gold since 2001 confirms the soundness of Harry Browne's original PP allocation strategy. His strategy provides over a 9% annual return since 1972. How much longer of a period than 36 years do you need before you say that the strategy may be a sound one?

What portfolio allocation do you like going forward?

What has your investment return been for the past one and five year periods (if you care to share)?

Continued...

9-6-2008

APE: Investment returns? I retired a multimillionaire at 39. My average annualized returns are in excess of 14%. I'm down this year, but I was also down in 2001 just prior to making a killing. I'm up about 90% total in the last 5 years.

What would I recommend vs this dog of a fund? I'd buy broad based equities over the next few months and if I was in the right area, I'd look for bargain priced real estate over the next couple of years. I like "endowment" style investments such as the vanguard managed payout funds.

I wouldn't touch commodities or things that the investor doesn't understand, especially if the investor is buying them simply because they went up a lot in the last couple of years. I wouldn't buy gold or gold related products until they hit about $300-350 an ounce. Then I'd buy a very small amount simply because there are a good set of people that'll buy it and run the price up, independent of any economically or financially sound reasons.

I'm not above making money on other peoples irrationality.

Continued...

9-6-2008

APE wrote:I'm not above making money on other peoples' irrationality.

ME: Irrationality is a relative term. You're the one who is down for the year, right?

Continued...

9-6-2008

APE: [The reason Japan-style deflation couldn't happen in the U.S. is] principally because socially, economically, financially and culturally the two countries have practically nothing in common.

To experience Japans deflationary economic situation, most americans would have to sharply reduce spending and begin massive savings programs, companies would have to stop capital expansion and begin shifting profits to paying off debt, and government supported corporate zombieism would have to spread far past the "big three".

I suppose one could argue that freddie and fannie and a couple of the financial institutions that have had to be bailed out are functional zombies, but I dont think that problem is going to continue on and be as widespread and tolerated as long term as Japan has. Most of this smells more like criminal endeavor that will end up being punished in some manner than broad based, widespread government sponsored corporate stupidity.

So I guess the thesis that strong deflation could happen here is possible, just highly implausible. And should it become prevalent, eh...stocks and bonds have traditionally produced fabulous returns in deflationary economies presuming that they werent accompanied by a depression.

You could say "But japans stock market has gone nowhere!"...the stocks of the well regarded non-zombie companies have done just fine. So I suppose the key learning from that would be to avoid index funds full of zombie companies.

I have to say that its sort of a boring topic to talk about, principally because it is so unbelievably unlikely to happen, and secondarily because its one of the first quick-draw responses often seen in goldbug conversations. As soon as someone points out that gold went nowhere for 30 years despite inflationary pressure, the "what about deflation just like japan!?!" comes out, only the person throwing that out usually has absolutely no idea about the implications that would have to be fulfilled for such a comparison to be fully drawn.

***

12-6-2008

ME: Ah, what a difference three months can make....

Very entertaining post. 

MediumTex wrote: It's sort of interesting to see how much has changed since then.

One thing that hasn't changed are the same ol' arguments people make against the PP.

In true APE fashion, the guy simply refused to acknowledge a table of very good annual returns data and basically tried to rationalize it away. 

AdamA wrote: Very entertaining post. 

MediumTex wrote: It's sort of interesting to see how much has changed since then.

One thing that hasn't changed are the same ol' arguments people make against the PP.

In true APE fashion, the guy simply refused to acknowledge a table of very good annual returns data and basically tried to rationalize it away. 

The guy reminded me of the villain from the first "Karate Kid" movie.

Don't ask me why.

MediumTex wrote:
The guy reminded me of the villain from the first "Karate Kid" movie.

Don't ask me why.

Did he try to sweep your leg?

AdamA wrote: Did he try to sweep your leg?

Worse--he took a shot at my PP.

MediumTex wrote:

AdamA wrote: Did he try to sweep your leg?

Worse--he took a shot at my PP.

Yet another example of why pure investment talk can never die.

This doesn't surprise me at all.  When I first started investing in the Permanent Portfolio people would want to tell me how dumb it was.  Gold and LTT seem to get the brunt of the criticism. 

That's a fun read.  Impressive how well everything you said has held up.  That APE's "cocoon of belief" is, like Travis Tritt, ten feet tall and bulletproof.  He makes an awesome villain.

MediumTex wrote: The guy reminded me of the villain from the first "Karate Kid" movie.

"STRIKE FIRST!  STRIKE HARD!  NO MERCY, SIR!"

This is a classic.  It belongs in the sticky threads at the top of the main page.

I’d like to revive this thread to the top of the heap because it’s so entertaining and filled with great content. The first page of historical posts is a phenomenal read.