This is a guest article by Jacob, creator of the personal finance blog, My Personal Finance Journey. In the article, Jacob analyzes the Permanent Portfolio, a theory presented by Harry Browne, to determine whether investing along the theory’s guidelines can help investors beat the stock market.
Investors in general always seem to be on the lookout for a sure-fire strategy that they can use to outperform the market. Unfortunately, the reality is that these strategies are difficult-to-impossible to find. For this reason, I personally invest in a portfolio of passively managed low-cost index mutual funds from various asset classes and rebalance back to my asset allocation targets periodically.
Since my investing strategy does not take up too much time to maintain each month (in fact, individual stock investors might even call it “boring”), I am constantly interested in learning about new investing techniques and analyzing them to see if they have any merit.
One of these techniques/strategies I’ve learned about and analyzed over the past few months is The Permanent Portfolio created by Harry Browne in his book, Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.
What is the Permanent Portfolio?
The goal of The Permanent Portfolio is to provide safety and stability in any economic climate to the money you cannot afford to lose. This is accomplished by selecting various investment components in such a way that at least one asset class is favored in any economic climate. The Portfolio components are as follows, each carrying equal weight for as long as you hold the Portfolio, employing annual re-balancing:
- 25% in stocks, which do well in times of prosperity.
- 25% in gold, which does well in times of inflation.
- 25% in bonds, which increase in price during times of deflation.
- 25% in cash, which does well in times of tight money/recession.
Existing studies on the Permanent Portfolio
There have been many studies that have looked at this type of investing over the past 5 years. Overall, the conclusions and opinions from these existing studies are mixed. Craig from Crawling Road saw enough evidence from his study of the efficacy of The Permanent Portfolio, and he appears to have adopted it successfully to his investing strategy.
On the other hand, William Bernstein and Geoff Considine feel that while The Permanent Portfolio strategy itself has merit, individual investors who flock to this strategy are most likely “chasing returns” and probably lack the discipline to stick to the allocation dictated over the long-term, causing failure/loss of money to occur. This is due to the fact that the portfolio could be essentially flat-lined while the overall stock market is increasing 20%! An investor must have the discipline to stick to the strategy in these sorts of times.
I was not ready to automatically execute The Permanent Portfolio strategy for my own investing after reading the existing studies above for the following reasons:
- The use of raw index prices in existing studies is not ideal. I would want to still see good performance and risk trends when common investment vehicles (ETFs or index funds) are used exclusively to construct the portfolio.
- Use of physical gold metal holdings in existing studies is not ideal. Since the studies discussed above used gold market prices, I’d want to perform my own analysis using an index fund or ETF to see how performance held up without the use of physical metal.
- Permanent Portfolio performance comparison against a more aggressive stock asset allocation. In the existing studies, the most aggressive asset allocation that was compared against The Permanent Portfolio was a 60% equity, 40% bond asset mix. However, for a younger person such as me who can take on more risk, I would be curious to see how the performance compares to a more aggressive equity asset allocation, such as 75% equity, 25% fixed income.
- Use of yearly rebalancing in existing studies is not ideal. I currently employ monthly portfolio analysis (and rebalancing if needed), and as such, I’d be interested to find out how The Permanent Portfolio fairs using monthly rebalancing analysis.
Refined Permanent Portfolio performance analysis
In order to address the four considerations in the previous section, I set about defining the financial instruments that would construct The “Refined” Permanent Portfolio, a hypothetical portfolio consisting of a $10,000 starting value. The components I selected are shown below.
- 25% in stocks – Vanguard S&P 500 Index Fund (ticker symbol: VFINX).
- 25% in gold. Vanguard Precious Metals and Mining Fund (ticker symbol: VGPMX).
- 25% in bonds. Vanguard Long-Term Treasury Fund (ticker symbol: VUSTX).
- 25% in cash. Vanguard Short-Term Federal Fund (ticker symbol: VSGBX).
The table below summarizes the performance of the Refined Permanent Portfolio described above over the last 20 years (ending the beginning of October 2011) compared to a 100% stock and a 75% stock, 25% bond portfolio. The historical prices data source is Yahoo Finance. Monthly rebalancing is performed to maintain the appropriate asset allocation targets.
Examining the table above, it can be seen that the Refined Permanent Portfolio does indeed outperform both the 100% stock and the stock/bond portfolios by a significant margin, as evidenced by nearly a 60% improvement in return on your original investment (20-year overall ROI), along with exhibiting 30-70% lower risk (lower standard deviation of annual returns).
Essentially, The Permanent Portfolio resulted in overall greater returns because it is insulated against the big decreases in price stemming from the often-volatile stock market. This phenomenon is best illustrated by the graph below, which shows the investment value growth of a $10,000 starting investment in the Refined Permanent Portfolio (blue plot) vs. a 100% stock portfolio (red plot).
The enhanced stability of the Permanent Portfolio was especially apparent in the 1997-2002 time frame (see black square in graph below), when the 100% stock portfolio first increased by more than 100%, only to then decrease nearly 50% in one to two years. The Permanent Portfolio was protected from this huge swing in prices, effectively preserving investor capital.
Should investors incorporate the Permanent Portfolio?
Because of the consistency of the Permanent Portfolio over the past 50 years in either being competitive with or exceeding the long-term returns obtained using traditional stock/fixed income portfolios, I am convinced that The Permanent Portfolio will continue to perform well over the long-term.
However, I believe that investors should only adopt the strategy in full if the following conditions are true.
- They will truly stick with it over the 20 years needed to obtain results competitive with or beating stocks, or
- If they are merely looking for a conservative (not market-beating) strategy to preserve capital and stay ahead of inflation (which coincidentally, is the true goal for The Permanent Portfolio).
However, honestly, I feel that few investors (myself included) will have the resolve to stick with the strategy for the long-term, for the reasons mentioned below.
- The majority of investors that are interested in The Permanent Portfolio at the current time are simply looking at it as a possible way to “beat the market,” and not as a method to preserve capital, as it is truly intended.
- The Permanent Portfolio strategy’s returns have a low correlation with the returns of the stock market (a correlation coefficient of 0.58), meaning that if you employ this strategy, you’ll only enjoy any gains happening in the stock market about half the time. (Tthink about completely being excluded from the euphoria of the increase in the stock market in the late 1990’s. Would you be OK with that?) In my opinion, the low correlation of The Permanent Portfolio with the stock market makes it nearly impossible for investors looking to aggressively grow their money to stay with The Permanent Portfolio strategy.
Instead, most investors would be better served by sticking with an investing strategy using and a more “traditional” asset allocation that has a slightly higher correlation with the overall market.
Do you think that the Permanent Portfolio will continue to perform well in the next 20 years? Do you feel you’d have the discipline to stick with the strategy, even if it meant underperforming the rest of the market for long periods of time?
The complete set of calculations of the historical performance of the “Refined” Permanent Portfolio, correlation coefficients matrices, and price history of the proposed index mutual fund Permanent Portfolio is included in this Google Docs Spreadsheet.
Published or updated February 27, 2012.