A Hypothetical

[Fragile Bill]

The HBPP is comprised of investments in three volatile asset classes and one non-volatile asset class.  The HBPP is a long-term investment startegy.  The HBPP has benefited from the 30-year bull market in 30-year Treasury bonds.  Given the 30-year bull market in 30-year Treasury bonds, only one of the two remaining volatile asset classes needed to be in favor for the strategy to perform well.  During most of those years, either stocks or gold was in favor (and sometimes both).  However, if over the next ten years, the yield on 30-year Treasuries rose to the average of the past 35 years (approximately 7%), is it fair to say that the strategy would probably not perform nearly as well as it has over the past 30?

[frommi]

Yes, but nobody wants to hear that in this forum 

[Pointedstick]

If that happened, cash wouldn't be quite so non-volatile anymore! Instead of being the boring drag on returns, it would start throwing off serious payments. We'd see threads bemoaning the idea of holding bonds when cash preserved your flexibility and was only yielding a little bit less. The coupon payments would start to become a real component of the PP's total return again as opposed to a distant memory. And there's no telling what gold or stocks might be doing during that time.

In addition, I think it's not at all unlikely that current rates are near a "new normal" for at least the next decade or two.

[Pointedstick]

Another point is that this worry could apply to any asset class, really. If stocks fell for the next decade, that would also be a drag on portfolio returns. Same with gold. But for some reason, a lot of people seem more comfortable predicting the impending death of bonds than they are stocks or gold. This despite the fact that in the last 30 years, gold has died once and stocks have died twice!

[MediumTex]

The years in which the PP has performed best were in the 1970s when only ONE of its volatile asset classes was performing well (gold) and the other two were both in secular bear markets (stocks and bonds).

I'm not concerned about the portfolio's ability to get along okay if just one of the volatile assets is performing well.

As PS notes, too, cash has a way of springing to life when you least expect it and performing a valuable function in the overall portfolio.

In other words, the OP was not really a hypothetical scenario.  We've been there and done that and it worked out fine.

Even when ALL THREE of the portfolio's volatile assets are not doing well, as was the case for a period of time in the early 1980s, the overall portfolio is still pretty stable because of the volatility dampening effects of cash and any PP losses tend to be far less severe than most other allocations will be experiencing under the same conditions.

[craigr]

However, if over the next ten years, the yield on 30-year Treasuries rose to the average of the past 35 years (approximately 7%), is it fair to say that the strategy would probably not perform nearly as well as it has over the past 30?

Anything can happen of course. But if LT bonds are paying 7% what is the real return? Is it 3-4% real (inflation in the 3-4% range)? If that is the case, then you'll probably find many stock portfolios may not do as well either. I suspect a lot of stock lovers would turncoat if they thought they could lock in some solid real return rates with the relative safety of long term US bonds.

Then again, the 7% return could be because inflation is getting high and going higher. So why would that not be good for gold and stocks which also buffer inflation to a degree?

Or we could see bonds fall down to 2-3% range as they've been in Japan for the past 20+ years. Today's rates may seem like a dream come true in that case.

So really there is no way to know. For every scenario someone gives me for bonds yields going through the roof, I can probably think of a scenario where the exact opposite happens and would be just as plausible.

And to answer your question about past 30 years projecting into the next 30. Really what other strategy can promise to do as well going forward as in the past? Even heavy stock portfolios have had very long periods of underperformance and volatility that have tried the patience of investors. The U.S. will be much different in 30 years just as it was 30 years in the past. The only thing you can do is diversify and not assume anything.

[AdamA]

Yes, but nobody wants to hear that in this forum 

Didn't interest rates go up in the 1970's?

The PP did pretty good then, right?

[MediumTex]

Yes, but nobody wants to hear that in this forum 

It's not that we don't want to hear it--it's that we've already heard it countless times and in each case pointed out how the PP's 40 year history shows that under the conditions being proposed where interest rates are rising and stocks aren't doing well, the PP still does fine.

In the same way that a person from the 19th century who didn't understand the physics of aircraft design might consider someone who climbed aboard a modern airplane to be a complete idiot, it is sometimes tempting to criticize the PP if one doesn't fully understand the economic and philosophical concepts that went into its design.

Plenty of people have told me that the PP couldn't possibly work.  When I show them contrary data, some of them won't even look at it because they don't feel like they need to--they are that certain they are right.

[frommi]

The problem

If that happened, cash wouldn't be quite so non-volatile anymore! Instead of being the boring drag on returns, it would start throwing off serious payments. We'd see threads bemoaning the idea of holding bonds when cash preserved your flexibility and was only yielding a little bit less. The coupon payments would start to become a real component of the PP's total return again as opposed to a distant memory. And there's no telling what gold or stocks might be doing during that time.

In addition, I think it's not at all unlikely that current rates are near a "new normal" for at least the next decade or two.

Cash rates are controlled by the FED, when inflation does not explode there is no reason to increase the short interest rates. And because we have no good long term data for the PP in a rising-yield-environment, we are in untested waters for the PP. I for myself have decided to remove the cash portion, because it currently gives -2% Real Return. Perhaps i will re-add it when we have cashrates back at inflation levels. Btw. most FIRE-calculators show clearly that >=80% equities was the way to go for retirement in the last 140 years, you just have to buy and hold no matter what happens.

[Pointedstick]

So you're worrying about a situation in which 30-year rates hit 7% but 1-year rates are still basically 0%? If inflation remained low, wouldn't that decimate the stock market as people poured into the high-yielding bonds and then depressed their rate right back down again? And if inflation was high, wouldn't gold be going crazy?

[Gumby]

On April 17th, 2005, Harry Browne answered a listener's question on how the Permanent Portfolio would perform during a period of rising interest rates. I've taken the liberty of transcribing the first 10 minutes of that episode for everyone to read. If you'd rather listen to the episode yourself, you can download that episode from Craig's archive here:

Harry Browne Investment Radio Show: April 17th, 2005

Here is Harry Browne's response:

[01:37]

HARRY BROWNE: A question from "Jim" out in cyberspace...he says, "Your [Permanent] Portfolio seems to have a proven track record over a long period of time and through many different increasing investing environments. But, has the environment really been all that different over this period of time? Haven't we been enjoying a 20+ year period with down-trending interest rates? Fluctuating of course, but trending down. As you point out, a falling interest rate environment is good for both the stock and bond portions of the portfolio. Also, through most of this period, we've had a much lower rate of inflation than we experienced in the '70s. Would this have had the effect of keeping the cash portion from hurting the portfolio over most of this period?"

So, Jim goes on to say... I'll paraphrase the rest of it. He's worried that an inflation scenario gives you only gold as the one asset performing well. And he says, "Not to predict, but if this does happen, do you think the Portfolio could maintain the purchasing power of the invested funds?"

Well, Jim, the fact of the matter is that the Portfolio did very well during the 1970s. And I don't know if you're old enough to remember the '70s first hand, but inflation was really out of hand in the '70s. And it seemed as though we just kept bouncing back and forth between inflation and recession. And the inflation rate hit something like about 8% in the early '70s, backed off a bit. Then it went up to 12% later in the decade, backed off a little bit. And then went up to 14% in 1981. And stocks were not doing well. Bonds of course were doing terribly, because interest rates kept rising and rising. We finally hit a prime rate of 20% and a T-Bill rate of 15%. And I believe the rate on Treasury Bonds finally hit about 12% or 13%. And so, bonds were really in the tank, as they say. And of course, cash was not any help at all during such an inflation. But the fact of the matter is that the Portfolio kept growing during that period. Because gold went up 20-times over.

Now, I don't think we could count on gold going up 20-times over in the next run-up in inflation and gold. And the reason we can't count on the same result is because that result of the '70s was partly from the great inflation of the '70s and also partly from the fact that gold had been price controlled at $35 an ounce for a period of 35 years, that finally ended in 1968. And after a period of market time, gold really took off in the early '70s. And it was making up for lost time for those 35 years that it had been held down in price. That always happens when you lift price controls. Whatever was price controlled goes up much faster than the rate of inflation.

But, gold goes up much faster than the rate of inflation anyway, simply because its a powerful, leveraged investment — leveraged in itself, not leveraged by borrowing money. And I would think that in the next inflation — if we had something similar to the '70s — you could count on gold going up at least five or ten times over. In other words, gold would wind up at somewhere around $2,000 and possibly as high as $4,000. Right now that seems...that's in the stratosphere, that just seems impossible. But, I have to tell you that when I wrote my first book, How You Can Profit From the Coming Devaluation, published in the 1970s, I made the asounding forecast in that book...it wasn't really a forecast, but I talked about the idea of gold going to $70 or even $100 an ounce — when it was at $35. And that seemed astounding.

But, the truth is, that gold actually went to $800 before the period of inflation was over. Now $800 was way over the mark. And so it came back down again, and it finally bounced off at about $300, and came back up a little bit. But, there was quite a period there where gold was in the $300 to $400 range, and we have to think that that's probably the equilibrium where it belonged. And that was 10-times over the point where it had started in the early '70s.

So, yes, I do believe that gold is very, very powerful. Powerful enough to pull the entire portfolio upward during a period of turmoil caused by inflation.

And that's the point of the Portfolio. We have to remember that investments that are rising have a bigger impact than investments that are falling. In investment that is falling goes down 15, 20, 25, 30, 40 percent during a bad, bad bear market. But, investments that are rising, in a bull market, go up 100%, 200%, 300%, or in the case of gold, 1,000%. So, that investment that is rising, a single investment, can be strong enough to carry the whole portfolio upwards. Gold during inflation. Bonds during a deflation, ought to be able to carry the whole portfolio upward, while stocks and gold are falling. And, during the prosperity we have the benefit of two investments that pull the portfolio upward — stocks and bonds — why gold may be falling. And cash is relatively neutral. So, the whole concept of the Portfolio is built around the idea that the winning investment will have a bigger impact on the outcome than the losing investments.

Now, if you don't think that's true, what are you going to do?

The only alternative to the Permanent Portfolio concept is to speculate. To say, 'I think this is what's about to happen and I'm going to put all, or most, of my money in that.' In other words, during a period you think inflation is here to stay for awhile, you put 70% of your assets in gold. Well, if you're wrong, if the gold price goes up a little, inflation goes up a little, and then comes falling back down, you might take an enormous loss, because you won't have a strong other investment in there to carry the portfolio upward and offset the losses in gold — which is maybe three times the impact on the portfolio as the winning investments because there's three times as much gold as the winning investment.

So, I hope that clears this up. If not, give me a call and let's talk about what's on your mind, about your money...

[craigr]

Yes, but nobody wants to hear that in this forum 

It's not that we don't want to hear it--it's that we've already heard it countless times and in each case pointed out how the PP's 40 year history shows that under the conditions being proposed where interest rates are rising and stocks aren't doing well, the PP still does fine.

And not only have we heard it 1,000 times, but there is always an asset in the portfolio that people hate. So when gold was doing well and stocks poorly we had people complaining that the portfolio should own more gold. Now stocks are doing great and gold is in the doghouse and people say it should own more stocks. Bonds are doing badly as well, so obviously that means the portfolio should dump all the bonds or move maturities down. Cash is negative yield so obviously it's useless and we should also buy more stocks with it (now that stocks are at an all time high of course). Etc. Round and round it goes.

[MediumTex]

Cash rates are controlled by the FED, when inflation does not explode there is no reason to increase the short interest rates.

I agree.

And because we have no good long term data for the PP in a rising-yield-environment, we are in untested waters for the PP.

I disagree.

We have the entire decade of the 1970s.  A decade of data is enough to draw some general conclusions about how well an allocation strategy works under a particular set of market conditions, such as rising yields when the stock market is doing poorly.

I for myself have decided to remove the cash portion, because it currently gives -2% Real Return. Perhaps I will re-add it when we have cash rates back at inflation levels.

Most people should have some emergency cash for a variety of reasons, and this is one of the many functions of the cash in the PP, regardless of what short term rates are doing in relation to inflation.

Btw. most FIRE-calculators show clearly that >=80% equities was the way to go for retirement in the last 140 years, you just have to buy and hold no matter what happens.

You have to also make sure you pick the right stock market at the beginning of the 140 year period.

If you pick the wrong stock market, you can expect to encounter catastrophic losses many times along the way.

[craigr]

If you pick the wrong stock market, you can expect to encounter catastrophic losses many times along the way.

But what do the catastrophic failures of the Japanese, German, Italian, Chinese, French, Italian, Russian, etc. markets matter to history? The U.S. will be the same forever and nothing could ever possibly go wrong! In fact, I bet the EU will still be the same in 100 years as well. It's gone swimmingly so far.

[Gumby]

If you pick the wrong stock market, you can expect to encounter catastrophic losses many times along the way.

Do you mean to tell me that the results of the Japanese, German, Italian, Chinese, French, Italian, Russian, Indian, Brazilian, etc. on backtests might actually matter in terms of assessing true stock market risk historically? Surely you jest!

Not only that, but as you showed in your 2011 post, all of the über long term 200-year equities performance backtesting is done on "perfect" indexes that never even existed!

Crawling Road: The Misleading Stocks for the Long Run Chart

Additionally, as Bogle once wrote — regarding that same 200 year equities backtesting — in Common Sense on Mutual Funds:

"These long-term data cover solely the financial markets of the United States. (Most studies show that stocks in other nations have provided lower returns and far higher risks.) In the early years, the data are based on fragmentary evidence of returns, subject to considerable bias through their focus on large corporations that survived, and derived from equity markets that were far different from today's in character and size (with, for example, no solid evidence of corporate earnings comparable to those reported under today's rigorous and transparent accounting standards). The returns reported for the early 1800s were based largely on bank stocks; for the post-Civil War era, on railroad stocks; and, as recently as the beginning of the twentieth century, on commodity stocks, including several major firms in the rope, twine, and leather businesses. Of the 12 stocks originally listed in the Dow Jones Industrial Average, General Electric alone has survived."

Source: http://books.google.com/books?id=KCCl0TiBoPUC&pg...

So, yeah... Not only do you need to pick the right stock market, but you also need to pick the right sector of stocks during the single greatest economic boom in the history of mankind.

Oh, and you need to be able to stomach every economic and political panic along the way. Most people can't do that.

[frommi]

So you're worrying about a situation in which 30-year rates hit 7% but 1-year rates are still basically 0%? If inflation remained low, wouldn't that decimate the stock market as people poured into the high-yielding bonds and then depressed their rate right back down again? And if inflation was high, wouldn't gold be going crazy?

No, i am worried about the current situation. I don`t see inflation going out of whack like from 1970-1980 in the next 10 years. 50% of the PP are currently destroying your real wealth. And gues what, it is not gold! it is cash and bonds. And this is granted, there is no speculation in this assumption.

[Pointedstick]

So you're worrying about a situation in which 30-year rates hit 7% but 1-year rates are still basically 0%? If inflation remained low, wouldn't that decimate the stock market as people poured into the high-yielding bonds and then depressed their rate right back down again? And if inflation was high, wouldn't gold be going crazy?

No, i am worried about the current situation. I don`t see inflation going out of whack like from 1970-1980 in the next 10 years. 50% of the PP are currently destroying your real wealth. And gues what, it is not gold! it is cash and bonds. And this is granted, there is no speculation in this assumption.

I just checked my accounts and it looks like both bonds and cash have had significant losses in their capital value over the past few months, but the bonds are still yielding a real return.

Could you clarify what you mean?

[Fragile Bill]

In the 4 1/2 years between February 15, 1977 and October 26, 1981, the yield on 30-year Treasury bonds went from 7.70% to 15.21%.  During that time, the value of a $1000 bond dropped to $512.  Would anyone be willing to share a link to the data that calculates the numerical rates of return for each of the four asset classes from 1977 through 1981?

Today, with the 30-year yield at 3.65%, a hypothetical increase to 7% over the next ten years, which is a little less than the average over the past 35 years, would make a $1000 bond worth $588.

[MediumTex]

50% of the PP are currently destroying your real wealth. And gues what, it is not gold! it is cash and bonds. And this is granted, there is no speculation in this assumption.

Okay, let's take a look at the last five years of data and see what actually occurred:

2008:

Long Term Treasury Return: 22.5%
Short Term Treasury Return: 6.7%
Combined PP Treasury Holdings Return: 14.6%
CPI: .1%

2009:

Long Term Treasury Return: (12.1%)
Short Term Treasury Return: 1.4%
Combined PP Treasury Holdings Return: (5.35%)
CPI: 2.7%

2010:

Long Term Treasury Return: 8.9%
Short Term Treasury Return: 2.6%
Combined PP Treasury Holdings Return: 5.75%
CPI: 1.5%

2011:

Long Term Treasury Return: 29.3%
Short Term Treasury Return: 2.3%
Combined PP Treasury Holdings Return: 15.8%
CPI: 3%

2012:

Long Term Treasury Return: 3.5%
Short Term Treasury Return: .7%
Combined PP Treasury Holdings Return: 2.1%
CPI: 1.7%

***

Average Return for All Treasury Holdings in PP 2008-2012: 6.58%

Average CPI 2008-2012: 1.8%

Let's say that the CPI is wrong and let's double it to 3.6%.  The PP's treasury holdings still beat it by almost 300 basis points.

I think that you are saying what you believe to be true based upon things that noisy market commentators have said, but you are not just speculating in your assumptions, you are simply incorrect--50% of the PP's holdings in the form of treasuries are NOT destroying your real wealth.  It's simply not happening.  If you include 2013 YTD figures in the data above, your average treasury returns are still far above the rate of inflation.

[Tyler]

BTW, most FIRE-calculators show clearly that >=80% equities was the way to go for retirement in the last 140 years, you just have to buy and hold no matter what happens.

Well, most FIRE calculators only give stocks and bonds as an option. I have yet to find a single one that accounts for gold, RE, or other asset classes.  When they present no other options to handle inflation, I understand why stocks look so appealing.

If you search the forums here, there are good discussions on how the PP performs as a retirement portfolio. Short story - you'll be very satisfied.

[iwealth]

In the 4 1/2 years between February 15, 1977 and October 26, 1981, the yield on 30-year Treasury bonds went from 7.70% to 15.21%.  During that time, the value of a $1000 bond dropped to $512.  Would anyone be willing to share a link to the data that calculates the numerical rates of return for each of the four asset classes from 1977 through 1981?

Today, with the 30-year yield at 3.65%, a hypothetical increase to 7% over the next ten years, which is a little less than the average over the past 35 years, would make a $1000 bond worth $588.

That's why bond investors weren't obliterated during that time period - made up ground quickly with those massive rates. Not as rosy a scenario these days.

[MediumTex]

In the 4 1/2 years between February 15, 1977 and October 26, 1981, the yield on 30-year Treasury bonds went from 7.70% to 15.21%.  During that time, the value of a $1000 bond dropped to $512.  Would anyone be willing to share a link to the data that calculates the numerical rates of return for each of the four asset classes from 1977 through 1981?

Today, with the 30-year yield at 3.65%, a hypothetical increase to 7% over the next ten years, which is a little less than the average over the past 35 years, would make a $1000 bond worth $588.

1977:

Stocks: (4.4)
Bonds: (1.0)
Cash: 3.4%
Gold: 22.2%

PP Return: 5.1%

1978:

Stocks: 7.3%
Bonds:  (1.5%)
Cash: 5.2%
Gold: 36.5%

PP Return: 11.9%

1979:

Stocks: 22.8%
Bonds: (1.5%)
Cash: 10.1%
Gold: 125.6%

PP Return: 39.3%

1980:

Stocks: 32.4%
Bonds: (4.2%)
Cash: 13.8%
Gold: 14.7%

PP Return: 14.2%

1981:

Stocks: (3.9%)
Bonds: 1.6%
Cash: 18.6%
Gold: (32.9%)

PP Return: (4.1%)

***

1977-1981 Average PP Return: 13.28%

https://web.archive.org/web/20160324133 ... l-returns/

Remember that even as a bond is taking capital losses due to rising rates, it is still collecting dividend payments that dampen those losses in bond value.

[Fragile Bill]

Can you point me to the data behind the returns on the bond portion of the HBPP?  -1.0%, -1.5%, -1.5%, -4.2%, and +1.6% can't be right when bonds go from $1000 to $512 during the period.

[Fragile Bill]

In the 4 1/2 years between February 15, 1977 and October 26, 1981, the yield on 30-year Treasury bonds went from 7.70% to 15.21%.  During that time, the value of a $1000 bond dropped to $512.  Would anyone be willing to share a link to the data that calculates the numerical rates of return for each of the four asset classes from 1977 through 1981?

Today, with the 30-year yield at 3.65%, a hypothetical increase to 7% over the next ten years, which is a little less than the average over the past 35 years, would make a $1000 bond worth $588.

That's why bond investors weren't obliterated during that time period - made up ground quickly with those massive rates. Not as rosy a scenario these days.

The $512 and $588 that I quote is the NPV of all cash flows including the interest stream.

[MediumTex]

In the 4 1/2 years between February 15, 1977 and October 26, 1981, the yield on 30-year Treasury bonds went from 7.70% to 15.21%.  During that time, the value of a $1000 bond dropped to $512.  Would anyone be willing to share a link to the data that calculates the numerical rates of return for each of the four asset classes from 1977 through 1981?

Today, with the 30-year yield at 3.65%, a hypothetical increase to 7% over the next ten years, which is a little less than the average over the past 35 years, would make a $1000 bond worth $588.

That's why bond investors weren't obliterated during that time period - made up ground quickly with those massive rates. Not as rosy a scenario these days.

The $512 and $588 that I quote is the NPV of all cash flows including the interest stream.

Maybe it's not.  You might re-check your data.

Just eyeballing it, I wouldn't expect overall losses to be that great based upon the interest rate moves you are describing.  Here's why:

Starting value of bond paying 7.7%: $1,000 (interest reinvestment is assumed)

Year 1 Interest: $77
Year 2 Interest: $82.93
Year 3 Interest: $89.31
Year 4 Interest: $96.19
Year 5 Interest: $103.60

Total Interest Over 5 Years: $449.03.

If you are saying that at the end of the 5 years the $1,000 bond has dropped to $512, even though in the five years the bond has generated $449.03 in dividends, does that mean that if the dividends weren't included in the $512 amount, the $1,000 face value bond would only be worth $63?  There is an error in there somewhere.

If, however, you take your $512 figure and add the dividends to it, you get small losses each year, which is what the data I posted showed.