If you could describe your dream investment portfolio, what kinds of characteristics would it have? It would probably be one that had steady, positive returns with very little risk, was simple to set-up and maintain, and could weather any kind of investment climate. While a perfect portfolio is probably unattainable, the Permanent Portfolio gets pretty close.
The Permanent Portfolio was first advocated by Harry Browne, an investment analyst and two-time Libertarian Party Presidential nominee. He outlined the asset allocation strategy in his 1999 book Fail Safe Investing: Lifelong Financial Security in 30 Minutes.
In my last post where I reviewed a book that looked at investing from an ‘Austrian’ perspective, I mentioned how the Permanent Portfolio was a tool that regular retail investors can start using today to protect themselves against our current monetary confusion.
The theory behind the Permanent Portfolio is straightforward. Since the future is uncertain – especially in terms of inflation, deflation, growth and recession – why not construct a portfolio that can take advantage or defend against any of these combinations?
The portfolio is designed to weather any kind of storm and, most importantly, to protect against major drawdowns or losses. It is also constructed in a simple and understandable way so any investor can implement it.
A Portfolio for All Seasons
Here is how it works. The portfolio is divided into four basic asset classes: stocks, bonds, cash and gold. Allocation is equal between each of these classes so that 25% of the portfolio goes into each bucket.
Each asset class performs better in a different investing or economic climate. Stocks do well when the economy is growing and prosperous. I would also add that stocks do well when central banks are on the gas with easy money and quantitative easing.
Bonds do well in bear markets, as investors switch from stocks to bonds. They can also have good returns during prosperous times as well, as we have seen in the last multi-decade bond bull market, as interest rates continued to come down since the 1970’s.
Cash is king during recessions and panics, especially during credit defaults and bankruptcies. It also shines during deflationary periods because it not only holds its value compared to deflating asset prices and popping bubbles, but also because it gives investors ‘dry powder,’ which they can use to scoop up assets that are selling at a bargain.
Finally, regular readers of this site probably don’t need to be reminded of the value of gold. The shiny metal will do well in periods of both inflation (especially high inflation), as well as periods of deflation and panics (such as the last crisis.)
How Does the Permanent Portfolio Perform?
All of this sounds great in theory, but if you actually implemented this portfolio, how would you have done over the past few decades? In short, very well.
In an updated book on the topic, as well as on their website, Rowland and Lawson provide a backtest calculation of how the portfolio would have fared over 40 years from 1972 to 2012. The compound annual growth rate (CAGR) of the Permanent Portfolio is 9.6% for the period. This is virtually identical to the S&P 500 total return of around 9.7%.
Where things get really interesting is when you look at the risk and variation of those returns. A high CAGR over such a long period doesn’t say much about risk, or how those returns may have jumped around.
For example, if you were 100% invested in stocks – even in a broadly diversified index such as the S&P 500 – you would have lost 37% in one year: 2008. The biggest one-year decline for the Permanent Portfolio? Only about 4% in 1981!
Permanent Portfolio trounces everything else in terms of preservation of capital. A 37% decline means you need an almost 59% gain just to get back to even! If you look at the chart of the Permanent Portfolio performance, you will see a nice smooth line that is almost always increasing, compared to the wild gyrations of the stock market.
The Best Of All Worlds
The Permanent Portfolio has the ability to deliver gains almost as high as the stock market with dramatically less risk. It takes all of the tried and true wisdom of investing and combines it into one cohesive portfolio and investment philosophy.
First, it doesn’t try to time the market. Instead, it embraces uncertainty and admits from the outset that most investors don’t know what kind of environment the future heralds.
Second, it takes advantage of the power of diversification. Investment advisors will tell you to be diversified and own lots of different stocks; not bad advice, but they are still all stocks! Instead, to be radically diversified you need to be in asset classes that are completely uncorrelated to each other.
Third, the portfolio naturally allocates towards value and away from overvalued or expensive areas. Harry Browne’s original construction called for rebalancing anytime an asset class got as high as 35% of the portfolio or as low as 15%. So if stocks surge higher and become expensive, you will naturally sell some and move into safer assets. If stocks become cheap and oversold, you will allocate more to them.
Finally, it is very easy to implement and maintain. It can be done through low-cost ETFs or Vanguard mutual funds (although be sure to know the risks to different types of gold exposure.) Keeping investment fees low is also a sure way to boost returns. For those who want even less of a do-it-yourself approach, there is a company that offers a complete fund and ETF that tries to mimic the Permanent Portfolio (although there are some notable differences from the Permanent Portfolio described here.)
Let me be clear that this is not direct or personal investment advice, nor is it an endorsement of any company or product. A Permanent Portfolio approach may not be right for everyone. But the point is to start thinking about diversification and how you could tweak your own financial plan to preserve and grow capital, especially in such a volatile and confusing monetary environment.
Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.