It's most often during difficult economic times that the "permanent portfolio" comes back into vogue. But the strategy doesn't require a crisis to be successfully implemented. Nor is it only during steep market breaks that it reaps the greatest benefits. Indeed, the permanent portfolio has proven itself for over 30 years as a fundamentally sound means of protecting and growing investment assets.
The permanent portfolio is the brainchild of Harry Browne, a two-time Libertarian Party candidate for President of the United States, who claimed that his method of asset allocation was a fail-safe program for wealth creation. And the numbers support him. Between 1970 and 2003 the permanent portfolio averaged gains of 9.7% annually, with its single worst performance in 1981 when it lost a mere 6%. So what is the permanent portfolio, and what are the underlying investment principles that vouchsafe such remarkable returns?
1. Asset Allocation
Browne agreed with the modern portfolio theory that an important key to investment success is proper asset allocation. But Browne's allocations are unique in the world of investing; indeed, they're the essence of the permanent portfolio. Browne believed one's resources should be divided into four equal components, comprised of:
- 25% stocks made up of stock index funds, which would capture the full upside of any broad market move, i.e., the S&P 500 or Russell 2000. Browne patently did not advise investors to pick their own equities for this portion of the portfolio.
- 25% bonds, specifically long-term U.S. obligations, i.e., 30-year Treasuries.
- 25% gold, for which Browne recommended bullion coins rather than paper obligations.
- 25% cash, for which Browne recommended potentially the safest of all possible investments, a Treasury Bill money market fund (For more read What is a permanent portfolio?)
But why this allocation in particular? Browne believed that each of the aforementioned four asset classes would thrive in one of the four possible macroeconomic scenarios that exist.
- Stocks would thrive during periods of economic prosperity.
- Bonds would do well in deflation and acceptably well during periods of prosperity.
- Gold during periods of high inflation would rapidly increase in value as the only true defense against a deteriorating currency. (Read 8 Reasons To Own Gold.)
- Cash would act as a buffer against losses during a routine recession or tight-money episode, and would act well in deflationary times. (Read Recession-Proof Your Portfolio.)
What Browne understood – and attempted to exploit – was the almost complete lack of correlation between the four components. That is, each asset class rarely moves in tandem with any other, and if it does, it doesn't do so for a prolonged period of time. The phenomenon is also well understood by most sophisticated money managers, but Browne applied the principle in the creation of a defensive investing posture within a passive system.
The system Browne built was meant to be left alone. Trading in and out of positions defeated the purpose of the permanent portfolio. Instead, Browne advised the portfolio be rebalanced any time one or more of the four equal asset allocations strayed too far from its ideal 25% holding. So, if, for instance, after one year the gold holding appreciated to be worth 40% of the portfolio, while the other three segments remained equally proportioned at 20% each, one simply sold off the 15% excess in gold and distributed it equally among the three laggards.
Here, too, however, Browne set parameters. He advised rebalancing only when one segment dropped to below a 15% allocation or rose to above 35%. At that point only should all four asset classes be rebalanced to 25%.
This was the extent of the investor's involvement in the portfolio. Truly passive, the permanent portfolio does not rely on market timing or finding the best stock picking fund manager in order to succeed. (If volatility and emotion are removed, passive, long-term investing comes out on top, see Buy-And-Hold Investing Vs. Market Timing.)
There have been a number of studies that back-tested Browne's portfolio over three decades, and the results are impressive. In no single year was a loss incurred that was greater than six percent – and this was the first goal of Browne's project: to avoid taking a big loss. As for overall performance, the studies reveal that for the 33 years, between 1970 and 2003, the portfolio rendered 9.7% annually.
And for those interested in real time results that include the crash of 2008, there exists a Permanent Portfolio Fund (MUTF:PRPFX) that, although slightly modified from Browne's original model, provides an excellent sampling of what the permanent portfolio is capable of. Between 2003 and the summer of 2009 – a period which includes the dire results of 2008 – the permanent portfolio returned an annualized 8.92%.
In arguably the worst market in 90 years, that is, in 2008 alone (January 4, 2008-January 2, 2009) the fund dropped a mere 9.11%.
5. Risks and Modifications
The permanent portfolio fund is only one of many variations on the original theme promoted by Browne. And to date, it rates as very successful. The fund rating agency, Morningstar, dubs it with its highest five-star rating over three, five and 10 years and gives it five stars overall. Noteworthy for them is the minuscule standard deviation on the fund, which means investors sleep easier for the minimal "whipsaw" action in the fund on a daily basis. (The bell curve is an excellent way to evaluate stock market risk over the long term Stock Market Risk: Wagging The Tails.)
Managers of the fund have seen fit to deploy their resources in six target areas rather than four. They are: precious metals, Swiss francs, global real estate stocks, natural-resources stocks, domestic growth stocks and U.S. bonds.
The only generally-recognized drawback to the permanent portfolio (and, indeed, to the fund that shares its name) is that it will underperform broad sectors of the market for lengthy periods of time should there be an extended run in one particular asset class.
In the 1990s, for example, the permanent portfolio fund did not keep pace with the overall stock market, catching up only in subsequent years as bonds, cash and precious metals outperformed. In short, the permanent portfolio requires time to work. It should be considered a get-rich slowly scheme. (For a complete guide, see the Industry Handbook Tutorial.)
Asset allocation is widely understood to be the most important factor in generating long-term investing profits, and Harry Browne's approach continues to prove itself as sound a method as any for doing so. Even more so, perhaps, because it takes as its departure point the potential negative impact of all economic scenarios on one's investment portfolio. When it comes to investing, the best offense is a good defense.