Peering Into the Permanent Portfolio: Part 2

Here’s the second part of my interview with Craig Rowland, the blogger behind Crawling Road and a champion of Harry Browne’s Permanent Portfolio.

Any index investor who has studied diversification would agree with your overall idea, which is that a portfolio should be built to withstand a variety of risks and economic conditions. But what surprises a lot of people about the Permanent Portfolio is that it has equal buckets for each of the four asset classes. I can see using a portfolio that was 30% bonds, 10% cash, 10% gold and 50% stocks, or something similar. Why use a 25% allocation for all four?

I hear this from people all the time: “You should own less gold,” or “You should own fewer long-term bonds.” And this is something that Harry Browne got asked many times over the years. The original Permanent Portfolio concept did have a more elaborate split, but my understanding is that over the years Browne basically discovered that it is simpler to just keep it even. He didn’t notice any significant advantage to the other methods.

The other problem with splitting the assets in a disproportionate way is that you are making an assumption that you know what’s going to happen in the future. A lot of the market data that people use is only about 85 years’ worth. Prior to that there isn’t really much good data. And it’s really shocking when you think about it, that people draw from just 85 years of history. People said a couple of years ago that there is no way deflation is going to happen, because the Fed isn’t going to let it. But the Fed is just one player in the market: they don’t control everything, and now we are operating under deflation. Look at Japan: they have been in a deflationary funk for 20 years. So for me to say we should hold more of this asset and less of that one—that assumes that I know what is best going forward.

For instance, it was “obvious” to everyone in 1999 that any portfolio that didn’t have a heavy emphasis on stocks was going to suffer. And I’m sure now, in 2011, there are people who say that it is “obvious” that a portfolio should be 80% gold.

Just by having the four-way split, it seems to work well enough and I don’t want to tamper with it. When you look at the results, you have to agree with Harry Browne. I like simplicity, and the 25% split is not only simple, but it also works.

Well, I would argue that it’s reasonable to assume that stocks, because they are riskier than cash or short-term bonds, must have a higher long-term expected return if markets work at all. That doesn’t mean they will perform over the next two, three or even 10 years. But it should mean they will outperform over the next 30.

But you are using some weasel words here. You are saying expected and should. Japanese investors in 1989 expected the Nikkei index to continue to go up, and now here they are 20 years later with not so good performance. So I just don’t know.

I hear you, and I understand, and I tend to agree with your position. And my response is, if you can hang on for the ride, then go for it. But I would also say that life gets in the way, and sometimes you might need the money earlier, and you might not be able to wait things out. I would also say that, based on history, you don’t want to rely too heavily on stocks.

Rather than holding 25% cash and 25% long-term bonds, why not just hold 50% of the portfolio in a diversified bond fund that holds all maturities? Why the barbell approach?

First of all, I don’t recommend any total-market bond fund. You should only own the bonds of your own government: so in the case of Canada, you should only own Canadian government bonds. The reason is that the government can always pay their obligations by taxing people, or by printing more money as a last resort. It’s not going to default: at least, that’s a very small risk. Whereas if you include corporate bonds, or agency bonds, you never know. And that’s what happened in 2008: people got socked. So I don’t recommend blended funds.

You’re probably asking why I don’t just use an intermediate-term government bond fund. But I like the barbell: I like having that slug of cash, because it is very stable. It gives you the peace of mind when you look at the portfolio and see these other parts moving around. You know that you have this cash to cover living expenses, emergencies, whatever.

For investors who do want to put a portion of their portfolio in gold, is a gold ETF acceptable, or do you believe that people should actually hold physical gold?

When Harry Browne passed away, gold ETFs had not become that popular, although he was aware of them. Generally, gold is there for inflation protection, but it also guards against catastrophic situations. So the ideal in Harry Browne’s world was having some physical bullion under your immediate control, whether it is in a safe deposit box, or someplace secure near you, and also another slug of it overseas in a country like Switzerland. So he wanted geographic diversification, too. That is relatively painless to do for non-US residents, though it is now almost impossible to do here in the US—no Swiss bank is going to want to deal with you.