Gyroscopic Investing

Recently I had a rather lengthy conversation with a well known portfolio manager whom uses passive index instruments such as DFA & Vanguard products.  Your typical globally diversified stock-value tilt portfolio with bonds being kept to short term treasuries or high quality credit, no commodities or gold.  The following is a brief synopsis of his opinion of the PP versus a stock-bond portfolio.  Any truth to his statements?

"As for avoiding market declines, that really only matters if you don't
believe markets recover (which would be a first) or if you put money at risk
during a decline that you need to spend. If you do not have confidence that
markets will recover, then you should never invest at all. Markets bring
uncertainty. Investors have to accept/embrace that at some level."

"For a fund like the Permanent Portfolio, there is really nothing special
there. It's just another allocation that prioritizes non-correlation over
expected return driven by earnings, dividends, interest. I see that PRPFX has a return since inception (12-1-82) through 9/30/10 of
6.75% annually pre-tax. If I take a simple mix of 25% DFA Core 2, 25% MSCI
World ex US Value Index, 50% 5 year Treasuries, I get a back-tested return
of 10.49% annually. In a nutshell, PRPFX will ultimately deliver a return
commensurate with the risk it takes, which isn't much. In a short-term
market meltdown, yes, PRPFX will look good, but that only matters if you are
investing for a short period of time, which applies to very few people. But
it's not like the 25/25/50 mix above was a total failure from 9/30/07 to
9/30/2010 - it was still up about 4.5%, or 1.5% annually over the past 3
years. If you are investing for 20, 30, 40 years, why bother with funds
designed for the next 2, 3, 4 years?"

"If you are concerned about near-term market declines, consider paying off
all debt and making sure you are very confident in your budget and
employment before you invest. It's tough to take risk without starting from
a position of strength. At the end of the day, you can't avoid risk, you can
only exchange one form of it for another."

hrux wrote: Recently I had a rather lengthy conversation with a well known portfolio manager whom uses passive index instruments such as DFA & Vanguard products.  Your typical globally diversified stock-value tilt portfolio with bonds being kept to short term treasuries or high quality credit, no commodities or gold.  The following is a brief synopsis of his opinion of the PP versus a stock-bond portfolio.  Any truth to his statements?

Without risk there is no reward. Nothing new there. Avoiding market drawdowns needs to be balanced with growth. It's one thing to be a money manager and have client portfolios taking 20,30,40+% nosedives. It's another thing to be the client and watching it happen to your own money.

Heather, there is no right answer. Just what is right for your situation. The PRPFX mutual fund overweights inflation assets like gold, silver, Swiss francs. When those assets cool off the fund is going to do comparatively poorly. That's why I like the 25% split better.

If you want to hold more stocks there is nothing saying you can't do it in your variable portfolio. Only you know what your risk tolerance is.

The manager seems to only be concerned with the return of a portfolio, but he doesn't seem to consider volatility as being an important factor for the average investor. It's important, because most investors can't stomach high volatility. The Permanent Portfolio offers a moderate return with low volatility.

Here's what Harry Browne said on the Feb 20, 2005 Investment Radio Show (skip to: 23m 45sec). I'm quoting from the show here:

CALLER: [PRPFX] has done extremely well over the life of the fund, has it not?

HARRY BROWNE: Yes. Now there are going to be other funds that have a higher yearly return over a long period. But, they get that return with what I keep referring to as the 'roller coaster ride.' You have these wide swings where you're up one year by 30% and then the next year you're down 15%, and so on. Whereas if you could look at a graph of the Permanent Portfolio Fund or the kind of personal Permanent Portfolio that I recommend, what you'd see is just steady growth year after year, after year, of a more modest amount. In the case of the personal Permanent Portfolio that has gained 9% a year, over the last 30 years, and the Fund return has been similar with no big losing years at any time. So it's much easier to stay with that kind of a program, because you don't get into a period like 2000 or 2002 when the stock market is falling and your favorite mutual fund is doing badly and you think, 'Gosh, I gotta abandon this,' and do something else and you drop out of it right at the bottom as it starts to go back up again.

CALLER: [chuckling] That's kind of what I do with the Stock Market, as a fatter of fact!

HARRY BROWNE: Well, it's not the least bit unusual. And that's why stability is just as important as performance. Because a lack of stability can cause you to be anxious about it all the time. And secondly, to make poor decisions because the swings in the market affect you, and you can only ride it down so far, so you finally get out of it. And you may get out of it halfway down or you may get out of it right at the bottom.

Also, during an economic downturn people are more likely to access their savings to buffer against lost jobs and/or decreased income. Low volatility helps keep your savings intact when you need it the most. And low volatility allows your portfolio to steadily compound its returns. More importantly, low volatility allows you to sleep better at night.

Harry Browne always said that the Permanent Portfolio is only intended for the money that you can't afford to lose. For some people, that's 100% of their money. For others, it may be a portion their savings. The money that you can afford to lose goes into a Variable Portfolio that can be whatever you want it to be. If you're bullish on stocks, your VP can be 100% stocks. This allows you to tailor as much risk as you like into your investing.

craigr wrote:
Heather, there is no right answer. Just what is right for your situation. The PRPFX mutual fund overweights inflation assets like gold, silver, Swiss francs. When those assets cool off the fund is going to do comparatively poorly. That's why I like the 25% split better.

A slight correction: currently PRPFX overweighs stocks and bonds in lieu of cash. As to gold it holds roughly 20% in gold and 5% in silver. Due to this stocks tilt the fund tanked more than PP in 2008.

craigr wrote: If you want to hold more stocks there is nothing saying you can't do it in your variable portfolio. Only you know what your risk tolerance is.

This is an absolute PP gem - even though PP/VP split might seem as a pure mental accounting I personally found  that psychologically it helps very much to shift most of your risk into VP (if you have any VP ever - some people come to a conclusion they only need a PP).

Keep in mind that PRPFX was created almost at the moment that the great bull market in stocks began.  I would imagine that if the manager's recommended portfolio would not have looked nearly as impressive starting from 1970 (at the beginning of a long, flat, nasty stretch of the stock market that saw huge drawdowns.)

Keep in mind that I am not criticizing his choice of 1982 per se, as this is the date of PRPFX's inception.  But understand that a portfolio that is 50% stocks is going to look really good if you have your backtest "buy in" at the bottom in 1982 and then coast through the 80s and 90s.

His suggested portfolio sounds nice and solid so long as you can handle some volatility without losing your cool.  Personally, however, I do not believe that I would ever feel comfortable with a portfolio that contained no hard assets.  In addition, a portfolio with high volatility presents the very real danger that you are buying right before a big drawdown.  Imagine buying into Japan's Nikkei index in 1988 and then having your mettle tested for more than two solid decades with no recovery in sight after all these years.  I would not enjoy that at all.  Those are prime earning years that I know I will never get back.  25 years of fretting.  Ugh.

I would agree that the manager is usually right that markets recover.  But again, what about Japan?  I don't believe it is likely to happen here but in an uncertain world I have to acknowledge such possibilities.

Scenario #2: Imagine that it's 1998 and all of your friends are raking it in with their software and biotech stocks.  You're only getting your same old boring 6-10% or so per year in the Permanent Portfolio.  Can you tough it out without performance chasing?  We'll all face this one day and I'm sure the temptations will be enormous.

Either scenario carries risk so it's worth thinking them both through to see what works for your personal investment mindset.  First and foremost, do what makes you comfortable.

It's also worth noting that PRPFX has a bit more volatility than the 4x25% personal Permanent Portfolio, as shown here during the 2008 crisis:



And the following chart shows how stable the return of the 4x25% Permanent Portfolio is -- in real terms -- compared with stocks, and going back to 1970:



As you can see from the 1970s and early 1980s, stocks took a long time to recover when you adjust for inflation. The Permanent Portfolio had more steady returns through good times and bad. Yes, stocks have been a "better" investment from 1970 until today, but you would have needed nerves of steel in order to reap those higher returns.

Any fool can make things bigger, more complex, and more violent. It takes a touch of genius-and a lot of courage-to move in the opposite direction.
Albert Einstein

Clive, I've often wondered... is your signature intended to be sarcastic?  ;)

While I find the PP very conservative, it performs extremely well for such a conservative portfolio.  If you want the highest performance based on prior years, here's what the PP teaches you:

Yes, over the long haul, stocks will PROBABLY give you higher return than most other sectors, and if that's all you care about, FINE.  But if you look at the history of LT Bonds & Gold's reaction to when stocks have dropped over 10% in a year (VERY positive, as you all probably know), then you'll realize that a small portion of both can both smooth the portfolio AND increase returns.  Add a few more of LT bonds and some more gold to it, and you do even better: Smoother and more growth.  At some point you loose out on the growth, but that's up to the investors.

In my excel calculations, I found that to get the maximum possible returns out of stocks, LT bonds, & gold, since 1972 (to November 2010), you only need about 60% stocks.  Once you try to add more stocks at the expense of gold & LT bonds, you not only lose growth, but you get more volatility.  This was extremely interesting (& fun) for me to see, because if I told some people my age that I'm in a 60% stock portfolio, they'd probably think "What an idiot... how conservative do you really want to play it."

Advisors who push stocks (no problem with that... as they have pretty great returns priced in (assuming things go as planned)), amazingly ignore other assets that, based on history, will actually IMPROVE & SMOOTH performance.... and instead throw you in some corporate bond fund if you feel your risk tolerance isn't high enough.  The more I look at the PP and see how the asset classes behave, the more I think the financial services industry is a complete joke.

Correction: If you take the asset classes back to 1972, the best return you can achieve (if Gold & LT treasuries are equally weighted) is with Stocks at 50%.

That's right, you only have to expose yourself 50% to stocks over the past 40 years to get the best possible returns, using gold & LT treasuries as a counterweight.


Thing is, I tried to be fair, so I bumped it to starting in 1974, and then you need a lot more to maximize returns, becuase you're missing out on 2 amazing gold years.  That said, a 60/20/20 (Stocks/Bonds/Gold) portfolio still beat Stocks alone if carried to November of 2010 from 1974.

I've used these facts to try to convince my dad to change his ways... he currently is almost all stocks at the age of 64.  Insane... I know, but when I finally illustrated it this way, I could finally convince him that these are the other assets to own.

I think the replies here are very good. As has been mentioned, there will often be temptation when your friends are bragging about their soaring stock portolios. So, let your variable portfolio (vP) soar. If I could time the stock market to not tank just when I'm about to retire, I would only have a vP. Since I cannot perform that kind of magic, I'm building a PP.

One only has to read through some of  the boglehead / diehard forum pages of 2008-2009 to see the heartache of 50- and 60-somethings who did stay the course and who saw a carefully nurtured portfolio lose big-time, right when they needed it. There was even anger directed toward a girl in her twenties who innocently expressed excitement in the market plunge, as she was about to buy in for the first time.

dualstow wrote:...There was even anger directed toward a girl in her twenties who innocently expressed excitement in the market plunge, as she was about to buy in for the first time.

As we say in the Netherlands, one man's death is another man's bread...

To be honest, I was kinda excited about it. Except for the part where I lost 1/3 of my investments :-). But I did try to think about it as a good buying opportunity. Then again, if I'd been only a few years from retirement, I would have been rather bummed. Got me to where I'm now though with 1/3 of my money in the PP...

jmourik wrote: As we say in the Netherlands, one man's death is another man's bread...

Hmm, never heard that one, although there is something close in English.
...

Got me to where I'm now though with 1/3 of my money in the PP...

Same here. I have a long way to go to reach 1/3, but it's the stock drops and those threads that got me here, while there's still plenty of time.