Peering into the Permanent Portfolio: Part 1

On Monday I introduced the Permanent Portfolio, an investment strategy created in the early 1980s by Harry Browne. It calls for investors to hold equal amounts of stocks, long-term government bonds, gold and cash. I recently spoke to Craig Rowland, the blogger behind Crawling Road, to learn more about the ideas behind the Permanent Portfolio.

What attracted you to the Permanent Portfolio?

My background is computer security, so when I test something I always start by trying to break it. And when I looked at traditional index fund portfolios, I noticed there were periods of time where they basically broke. By that I mean they either had significant declines, or they had extended periods where they didn’t have real returns after inflation. I noticed, for instance, that during the entire decade of the 1970s, a stock/bond portfolio didn’t even beat inflation. And I noticed that in other countries that type of portfolio failed over protracted periods of time. So I became convinced that the traditional idea of asset-class correlations was incorrect.

So I started looking at Harry Browne’s Permanent Portfolio, and honestly, at first I thought the guy was nuts. This idea of holding 25% of your portfolio in gold—I almost ignored everything he had to say. But I when I looked at the results and the economic underpinning of it, I said, “This guy is right.” What I mean is that he didn’t pick asset classes because they had some past correlations between each other. He picked the asset classes based on economic cycles, and that is really the secret.

Harry Browne broke up the cycles this way: inflation, deflation, prosperity, recession. Then it was a matter of figuring out which asset classes were going to do best during those conditions: gold for inflation, long-term bonds for deflation,  stocks for prosperity, and cash for periods of recession. And it doesn’t matter what caused the condition to occur: all that matters is that you hold an asset class that protects you from it.

I think one of the biggest wastes of space in financial books are pages and pages of asset class correlation tables. It is such a complete waste of information, because they don’t mean anything. People are puzzled as to why asset class correlations change over time. Well, they’re looking at the wrong pieces of information: the only correlation that matters is how that asset responds to what is going on in the economy. That is the only conclusion you can possibly reach.

So the idea is not that long-term bonds go up because stocks go down. It’s more correct to say that the economic conditions that cause stocks go down have some overlap with the economic conditions that cause long-term bonds to go up.

Exactly. And it’s not black and white: there are periods when economies are transitioning from one cycle to another and there is this murky area where the markets try to figure out what the heck is going on. In the fall of 2008, this is what happened. The stock market was collapsing and the long-term bonds didn’t pick up immediately: it took some time before the markets collectively realized that deflation was in progress. At that point, the long-term bonds went up over 30% by the end of the year. It wasn’t instantaneous—there is always this lag time.

That’s why I tell people not to look at their portfolio every day. I don’t look at mine very often: people would be very surprised at how rarely I look at my portfolio. The more you look at it, the more pain you are going to experience. Just let the asset classes do what they do.

The remarkable thing about the Permanent Portfolio is not so much its average annual return, but its low volatility. According to the historical returns on your website, it would have had negative returns only twice in 40 years.

You’re right, the volatility is very low, and this is something that Harry Browne noticed as well. He worked in the financial industry and he knew that volatility scares people off their investment plan. If you can have a portfolio that has lower volatility, even if it might have lower returns, you’re more likely to stick with it. And if you stick with it, those lower annual returns are probably going to deliver better long-term results than a very volatile portfolio, because when people experience big swings up and down, they’re probably going to quit. Or they are going to sell out at the wrong time and miss the recovery.

Having low volatility in a portfolio should not be underestimated. It’s very important, if only for your own sanity. You want to be able to control your emotions, and the Permanent Portfolio with its low volatility, I think helps control investor emotions. That is just as important as overall returns. It is easy to look at a spreadsheet and get excited, but when you are living through that market where you have 20%, 30%, 40% losses, but spreadsheet is not going to help you much.

The asset mix in the Permanent Portfolio really is a remarkable example of Modern Portfolio Theory in action, because you’ve achieved this very low volatility in the overall portfolio by using three extremely volatile asset classes.

I think Harry Browne really captured the essence of Modern Portfolio Theory. It’s like in chemistry—I can take very volatile elements like sodium and chlorine. By themselves, sodium is quite explosive and chlorine is toxic, but if you mix them together you get salt, which is benign. It’s kind of the same thing with this portfolio. You take different components that by themselves are extremely volatile, but when you put them together the result is actually low volatility.

A lot of people don’t understand that. They want to look at each asset in isolation, and I was guilty of that initially, too. When I first read about the 25% gold, I thought Browne was nuts, and then I read about 25% long-term bonds and I thought he was really nuts. But I have looked at it every way, and I’ve looked into every criticism, because my own money is at stake. But what I have decided over the years is that I sleep like a baby following this strategy.

This whole idea about the US and the debt crisis—everybody is writing me about it, and I’m telling them to just ignore it. You can’t do anything about it, and you’ve got a 25% slug of gold, so you’re going to be OK. And if everything gets fixed, and the gold goes down, well, you’ve got 25% in long-term bonds that are probably going to do well. So don’t worry about it. That has always been my attitude.

We’ll continue the discussion with Craig Rowland on Friday.