Gyroscopic Investing

I talk with people about the PP from time to time, and one common objection I hear is that it isn't something that could every really work because all of the assets would cancel one another out.

I understand the proper response to this objection, but I think that the basis for the objection is not based on logic so much as a false intuition that people have when they first hear of the PP.

The false intuition goes something like this: Non-correlated assets may behave in non-correlated ways, but the amount by which one asset rises is likely to be proportional to the amount by which another asset falls.  

While this intuition may be sound in other areas, with the PP it is very misleading.  As someone who studies the PP closely will discover, as an asset class is falling in value at some point the price gets "sticky" the closer it gets to zero.  Thus, it isn't uncommon for a PP volatile asset class to lose 40% of its value, but it IS uncommon for a PP asset class to lose 60% of its value, and a PP asset class virtually never loses more than 80%.

On the upside, however, the dynamic is entirely different--a volatile PP asset that is rising may hardly even notice that it has crossed the 100% appreciation mark relative to an earlier level.  Especially in a fiat currency world that is bubble-prone, volatile PP asset classes are likely to routinely see gains of several hundred percent.

The problem is that such gains seem inconceivable before they occur and after they occur people seem to forget earlier price levels (probably due to some sort of "anchoring effect" around the current market price).

For someone who is interested in having effective PP discussions with those who are not familiar with the strategy, it may be a good idea to anticipate this faulty intuition, because it seems to really hang a lot of people up and once it settles in their minds it can become hard to dislodge.

Yes,

I'd love to argue with anyone that thinks they have a better allocation... 60/40 stocks/bonds?  Throw in real estate?

I know I've tried to tweak the PP, but that's at least acknowledging the genius that's already there.  I haven't heard of too many tweaks to the PP that improve on what's already there.  Sometimes I wonder, "can it really be that good," but I wouldn't feel comfortable with anything else.

Tex - well done! and thank you!

I am trying to convince my wife that PP is the way to go - and her argument is exactly how you stated - she is a "stuff in the mattress person" - and to be honest - I did not know how to respond - this gets to the strategy exactly.

Now - what about just "bad luck' in the stock market in general?

I am ready (wife willing) to pull the trigger - (two days ago) - if I had - i would be negative - I panic when i am in a position - it ruins the joy of life!

furthermore I should be my own contra-indicator -
every time I jump on board a certain strategy- the strategy tanks immediately.

case in point - 15% est. return for pure PP for 2010
the average is about 9 %

so its had a great year

but now it's taking on the chin

difficult to plunge right in

mike in pepsicola

gonetowindsurf wrote: I am trying to convince my wife that PP is the way to go - and her argument is exactly how you stated - she is a "stuff in the mattress person" - and to be honest - I did not know how to respond - this gets to the strategy exactly.

Talk to her about currency crises throughout history and the way it plunders mattresses without even touching them.  Cash is no protection against inflation over time.

Now - what about just "bad luck' in the stock market in general?

The PP is about putting bad luck behind you.  It's about putting the whole concept of "luck" behind you.  It doesn't rely on accurate predictions--it simply takes what the market gives you.

I am ready (wife willing) to pull the trigger - (two days ago) - if I had - i would be negative - I panic when i am in a position - it ruins the joy of life!

The PP often requires a bit of operator conditioning.  You have to be persuaded that the strategy works in theory and in practice.  It can be difficult to end the habit of wanting to guess properly and imagining that you are doing something crazy by buying asset "X" (it's been LT treasurys in recent years).  Don't underestimate the difficulty of shaking this mental model of investing (i.e.--I must guess properly, listen to the right pundit, buy the right fund, etc.).

furthermore I should be my own contra-indicator -
every time I jump on board a certain strategy- the strategy tanks immediately.

case in point - 15% est. return for pure PP for 2010
the average is about 9 %

so its had a great year

but now it's taking on the chin

difficult to plunge right in

mike in pepsicola

The belief that every time you buy something it is going to tank is easily addressed with the PP by simply coming up with a plan to scale in.  This scaling-in plan would not be a market timing exercise--rather, it will give you time to psychologically acclimate yourself to this new philosophy of investing.

Just to turn your logic on its head a bit, if the PP is "taking it on the chin" right now, wouldn't that suggest that now would be a good time to get started?

In general, here are a few points to consider if you are close to getting some skin in the game:

- You must look at the portfolio as a package.  If you look at the individual assets it will drive you crazy.

- You must understand that you are not going to get any support or understanding from most conventional investment strategists (including the financial news media).  Those guys typically think they are way too smart to take a completely neutral stance toward future events.  Most of them also don't understand that there is money to be made from just such a stance (see the OP to this thread).

- You must give yourself time to get acclimated to the PP.  It will feel very strange at first (especially the gold).  You will wonder if you have made one more bad investing decision.  These feelings will wear away with time and actual success with the portfolio.

- The "Permanent" in PP means just that.  It's not designed to be tinkered with.  Just let it do its thing and enjoy your life.

Above all, make sure you are fully comfortable with and understand the PP approach.  It's not for everyone.  If you can get a year or so behind you with the PP strategy, though, I think the world will look like an entirely different place. 

Thanks for the post.  I understand your enthusisam and sense of uncertainty.  I think you are touching on things that most PP tire kickers think about.

MediumTex,

Be honest with me, when the "world was ending" in in 2008, and you finally got to see the PP handle a major deflationary crisis and financial crisis that almost brought us to our knees, and you walked away with over 1% positive return, you had to feel pretty good, and not just "neutral."  I mean, maybe not for your friends & family who were improperly invested, but to see the PP perform like that had to be a truly great feeling.

moda0306 wrote: MediumTex,

Be honest with me, when the "world was ending" in in 2008, and you finally got to see the PP handle a major deflationary crisis and financial crisis that almost brought us to our knees, and you walked away with over 1% positive return, you had to feel pretty good, and not just "neutral."  I mean, maybe not for your friends & family who were improperly invested, but to see the PP perform like that had to be a truly great feeling.

There is nothing like a big storm to make you feel good about investing in a cellar.

The PP really shined in 2008.  Note, however, that the PP was down quite a bit at one point in 2008 before the LT treasurys started performing well.  During times like that it's really important to understand the thinking behind the PP--it helps prevent capitulation. 

I think it's important to be realistic about our own emotions as well--it's easy to say you have a certain risk tolerance when filling out a mutual fund form, but it's another thing to be able to resist fear when the whole herd is being overwhelmed by it.  Few people are THAT independent.  It takes strong logic to put a leash on the reptilian brain when it's in panic mode.

Did you rebalance after/during 2008?  How did you feel about it... or are you just a PP complying machine now and you don't even question your rebalances?

moda0306 wrote: Did you rebalance after/during 2008?  How did you feel about it... or are you just a PP complying machine now and you don't even question your rebalances?

I was at an earlier stage of understanding.

I started using the PP strategy in mid-2007 or so.  By mid-2008, I was starting to get comfortable with it (and was moving more of what I would now call my VP funds into my PP) and when everything started going haywire I stopped adding new money to it for a while.  When it became clear that the world was not going to end I started adding VP money to my PP again, which allowed me to buy stocks and gold cheap.

This hits on another important point and it is this: When starting out I don't think there is any harm in rebalancing early if the alternative is abandoning the PP strategy altogether.  I will admit to taking some gains early myself (though it almost certainly cost me additional gains compared to what would have happened if I had just left things alone).  This is another part of the PP that just takes practice (i.e., waiting on your rebalancing bands).

Clive,

I meant cash under a mattress.

Tbills have historically tracked inflation reasonably well.

"The false intuition goes something like this: Non-correlated assets may behave in non-correlated ways, but the amount by which one asset rises is likely to be proportional to the amount by which another asset falls"

That's called inverse correlation, not non-correlation, and the problem is many people don't understand the difference.

Drewskers wrote: "The false intuition goes something like this: Non-correlated assets may behave in non-correlated ways, but the amount by which one asset rises is likely to be proportional to the amount by which another asset falls"

That's called inverse correlation, not non-correlation, and the problem is many people don't understand the difference.

Are you agreeing or disagreeing with my assessment?  Maybe I'm missing something, but it seems like non-correlated would be the better description of PP assets, since they move together at times and in opposite directions at other times.

I think that whether we are talking about inverse correlations or more casual correlations, this matter of zero being the bottom but the sky being the top seems to get by many people. 

I always visualize one of those progressive resistance workout machines where the harder you push the more the machine pushes back.  The harder you push on a PP asset class moving toward zero, the greater the resistance becomes.  As PP assets move up, however, any resistance that is encountered has nothing to do with whether the asset has gained 100% from an arbitrary starting point.

Same point as the OP, just said it a different way.

I am agreeing, just trying to introduce the proper terminology - maybe I should just reference an external source:

http://www.investopedia.com/terms/c/correlation.asp

I think a lot of people tend to think in terms of perfect positive correlation, or perfect negative correlation, and don't understand there can be non-correlation - and all points in between!

Historically, the four components of the PP are considered non-correlated. There are short-term aberrations during extreme market extremes, but the correlations always have reverted to around zero.

Here is a nifty tool for visualizing these relationships between various ETFs over time (try it between GLD and SPY, for instance):

http://www.etfreplay.com/correlation.aspx

Wow Tex -
Thanks for putting so much thought into my dilemma. You nailed it.
You covered everything.
Craigr should use your post as an "education and mindset" piece to PP.
I truly thank you for your wisdom and experience and taking the time to put it into words.
I am printing your post out and posting it on my computer screen. I so want a portfolio that minimizes risk, cuts out all the noise and provides decent returns over the long haul.
Good-bye CNBC, and all the fluff that goes with it.
Much thanks,
Mike in Pepsicola

Good post (and a very important one.)  How do you best explain this when someone asks you "why" the PP assets behave in this manner?  I have an intuitive feel for why this happens (and 40 years of data backs it up) but I've often wondered whether my understanding was incomplete.

I see it like this.  The PP is composed of four assets, three of which are quite volatile (plus cash, which further smooths the volatility of the "package".)  Let's play the role of an evil bastard pulling the strings of the economy in a way that breaks the Permanent Portfolio.  Can you hurt these assets without causing one or both of the others to pick up the slack?

If I want to hurt stocks and gold, I might build up and then pop a gigantic asset bubble and let the chips fall.  The deflationary aftermath would be a time of greatly reduced economic output.  Debt would be difficult to service and yields on bonds of all types would necessarily fall.  After all, with less money available in the system, interest rates will come down until the deflationary forces sort themselves out.  The yields on your (non-callable) 30 year bonds are so high in comparison that you get huge capital appreciation.  Can you do anything to keep that LT bond down without letting the pressure off the other two assets?  I can't think of anything.  (Cash will also do a good job here.)

If I decide I want to hurt stocks, bonds, and cash, I'd glue on my Ben Bernanke beard and crank up that printing press to bring on some inflation.  This will hurt bonds and stocks (in real terms), but gold will go crazy as the dollar comes under threat.  Once the dollar is no longer a secure store of value, investors are going to have a "strange new respect" for gold.  And with so very many more dollars than there are ounces of gold, the price is capable of taking off like a rocket.  Browne described gold as acting almost like a leveraged instrument for this reason and I've come to believe that he was exactly right.

If I want to hurt gold while keeping LT bonds under control, I need higher interest rates but a stable dollar, meaning that inflation must be tame enough that the dollar is secure.  Since interest rates are a combination of expected future real output and expected inflation, this means high economic output and a stable dollar with minimal government interference.  I can't imagine a more bullish situation for stocks.  Where else can they go but up?  Cash will also do fine here, though not as well as stocks.

The relationships between these assets and the way they interact though the ebb and flow of macroeconomic forces is what makes the portfolio work.  It's a beautiful thing.

How do most of you like to explain this "phantom mirror image of zero" phenomenon to people who don't "get" the PP?  (Or to those who don't believe in diversification at all!)

Lone Wolf wrote: How do most of you like to explain this "phantom mirror image of zero" phenomenon to people who don't "get" the PP?  (Or to those who don't believe in diversification at all!)

I think initial confusion may lie in the unusual composition of the portfolio, some in the way HB explained how it should work (based on his economic conditions), and some in its stellar returns under challenging circumstances.  But upon examination, this is simple stuff. 

The two Treasury classes (if using ST Treasuries vice Cash) and the Stock class all have varying degrees of risk premia, which premia have been rewarded certainly over long periods, pretty much as expected. I would not describe the classes as being "non-correlated".  The (Cash does have, basically, zero correlation);  ST Treasuries (if using them vice Cash) have low correlation with the Stocks (and somewhat so to the LT Treasuries), the LT Treasuries are, comparatively, far more correlated with the Stocks, depending on the maturity used.  Income is also produced by 3 asset classes.

That covers 3 asset classes.  Gold, while lacking the same type of risk feature as the other classes, can sometimes provide powerful negative correlation to any of the other classes (as do CCFs, albeit without a similar monetary component).  There are professional studies that examine how, why, and when Gold behaves in this "hedging" manner to these other classes. 

So overall, the portfolio—as a whole—tends to rise in value, explainable largely by the way markets work and price risk.  Regarding diversification, I think the work of Markowitz would also cover the HB PP, but explaining diversification to those who have chosen not believe in any form of it may be a challenge.  While wildly atypical, and at times spectacular in effect, there is nothing mysterious about the HB PP.