The Permanent Portfolio v. the Couch Potato

Let’s end the week with one final post about the Permanent Portfolio. Many readers expressed interest in this strategy, introduced by Harry Browne in the early 1980s. I’ve spent so much time on the Permanent Portfolio because I find it fascinating, and I enjoyed discussing its subtleties with Craig Rowland, who has studied it extensively. I’d like to thank Craig for taking so much time to answer readers’ comments so thoroughly over the last couple of weeks.

There are many things I like about the Permanent Portfolio, especially that it’s a passive strategy based on asset allocation and diversification, rather than forecasting or security selection. I also think it’s extremely low volatility is perhaps the best example of Modern Portfolio Theory in action. But I can’t encourage investors in Canada to adopt the strategy. Here’s why:

  • With just one quarter of the portfolio allocated to stocks, I don’t feel there is enough potential for long-term growth. Stocks have delivered—by far—the highest real returns over the 85-plus years for which we have good market data. Yes, they are volatile, but they have historically rewarded long-term investors with excellent growth in a way that cash, gold and government bonds have not.
  • Long-term bonds may be a hedge against deflation, but we have not seen significant deflation in Canada since the Great Depression. That’s not to say it can’t happen, of course, but the probability of it occurring does not justify such a large place in a portfolio. A 40% allocation to an index fund tracking the broad Canadian bond market would give you about 10% long bonds, 10% intermediate, and 20% short, with about a third of these in corporate bonds. This kind of diversified fixed-income portfolio offers a better risk-reward trade-off.
  • Gold can be a stellar performer during times of crisis, and I would never argue with an investor who kept a small holding (no more than 10%). But the idea that it is a hedge against inflation in the traditional sense—that is, in the sense of rising prices, as opposed to catastrophic hyperinflation—just isn’t borne out by the data. If our currency ever collapses I’ll regret not holding gold, and I can’t argue that will never happen. But in my opinion, the probability does not justify a 25% allocation.
  • Cash is not an investment: it’s savings. It’s perfectly prudent to keep cash on hand as an emergency fund, especially if you feel that a job loss, illness or other unexpected event would put your lifestyle in jeopardy. Perhaps that’s three to six months’ worth of expenses for a working family, or maybe as much as a two-year cushion for a retiree. But should someone with a $400,000 portfolio keep $100,000 in cash, where its real return is unlikely to be much more than 0%? The opportunity cost would be enormous.

Another look at the returns

One of the reasons that the Permanent Portfolio has gained popularity recently is that its returns have been impressive over the last dozen years or so, a period when stocks have performed poorly. And it’s not just the medium-term results that look impressive: according to the historical performance data on the Crawling Road website, the annualized return on the portfolio was 9.7% from 1972 through 2008. The page doesn’t include the data for 2009 and 2010, but the returns in both of those years was higher still.

How would the Permanent Portfolio’s returns have stacked up against a traditional index portfolio? Justin Bender, a CFA and adviser with PWL Capital in Toronto, was kind enough to run these numbers, and he’s allowed me to pass on the results to readers. You can download the Excel spreadsheet here.

Justin analyzed the Permanent Portfolio using Canadian data for T-bills (cash), gold and long-term bonds. For the stock allocation he used an even split of Canadian stocks and the MSCI World Index. Then he compared it against the Global Couch Potato’s allocation of 20% Canadian stocks, 40%  U.S. and international stocks (also using the MSCI World Index), and 40% Canadian bonds (all maturities). He was able to get data going back to late 1979.

The Excel file includes three worksheets:

  • The first indicates the volatility of the two portfolios. Justin measured the portfolios’ standard deviation over rolling three-year periods. You’ll notice that the Permanent Portfolio’s volatility is extremely low: it averages about 5.6%, compared with 8.5% for the Global Couch Potato.
  • The second worksheet gives the annual returns for the two portfolios. From 1980 through 2010, the Permanent Portfolio’s compound annual growth rate was 8.42%, compared with 10.32% for the Global Couch Potato.
  • How much difference did that added 1.9% a year make, compounded over more than 31 years? The final worksheet graphs the growth of $1 invested in each portfolio from December 1979 through June 2011. Each dollar invested in the Permanent Portfolio would have grown to $13.77. One dollar invested in the Global Couch Potato would have become $21.92.

30 Responses to The Permanent Portfolio v. the Couch Potato

  1. Preet September 10, 2011 at 1:41 am #

    1:35am on a Friday night (technically Saturday) and you’re discussing spreadsheets comparing two passive portfolio strategies and custom back-testing data.

    How could anyone ever argue with you?

  2. Canadian Couch Potato September 10, 2011 at 8:41 am #

    @Preet: I was drinking heavily (and alone) and needed an outlet.

  3. Superior John September 10, 2011 at 8:46 am #

    Great numbers Dan!

    Great spreadsheet, how can anyone agrue with Dan? Preet and I couldn’t. How many financial “experts” would attempt to?

    I just wish I would have had the ability 25 to 30 years ago to have this non sense type of figure research infront of me to be able to sort through the pysobabble information many of these “experts” spewed forth.

    Keep up the great forum for the 20 somethings and their future investments….

  4. Chris September 10, 2011 at 11:24 am #

    I’m not sure Justin’s analysis is fair; it seems like cherry-picking. By choosing 1980 as the start date, he selected a historical point at which gold was at its peak (and, depending on which currency and inflation numbers you use, still an all-time real peak). This very likely artificially depresses the return numbers for the Permanent Portfolio.’

    (And of course, choosing 2010 as an end-date also tilts the return numbers away from the Permanent Portfolio.)

    I suspect a series of Monte Carlo selections of start and end dates would show roughly identical performance between the two portfolios, with the lower volatility of the Permanent Portfolio giving it better risk-adjusted returns.

    (Also, I should have posted this in the previous thread… although there is limited correlation between gold and price inflation, there is a stronger correlation between gold and monetary (money supply) inflation.)

  5. Preet September 10, 2011 at 12:08 pm #

    Oh. That’s how.

    Of course it’s just back-testing. You could beat something on a risk-adjusted return basis for 100 years in the past and have the opposite result for the next 100 years.

    *Having said that* If Justin is going to re-run the numbers, it would be nice to see monthly figures, rolling returns and sharpe ratios. If he could take out the cash and redeploy to the remaining indices, that would also be interesting to look at too.

    The historical downside performance is pretty spectacular for the PP.

  6. Jon Evan September 10, 2011 at 12:28 pm #

    The striking beauty of the PP is its low volatility! That virtue alone is important because the ordinary investor will stick with it whereas the significant peak and valley volatility of the CPP will cause many an ordinary investor to bail out. There is just too much emotion involved for the ordinary investor to stick with it when day after day your return is plummeting! Human nature is that way. If you have nerves of steal you can hang on but few have those. I know I don’t.

  7. Raman September 10, 2011 at 1:17 pm #

    Thanks for the analysis, Dan (and Justin Bender). It’s something I’ve been meaning to do since you started discussing the Permanent portfolio, and now I won’t have to 🙂 Laziness truly is underrated.

  8. Pat September 10, 2011 at 6:50 pm #

    Dan, I’d be really interested in your thoughts on the following:

    Could you recommend the PP for shorter term investments, where you need the money in 10-20 years or less? For example, in an RESP when your child is, say, 5 years old. Yes, you would probably get a lower rate of return holding the PP for 30-40 years, but when your investment horizon is only 10-20 years, stocks and bonds may underperform. And the PP’s low volatility makes it attractive for the 10-20 year time period.

    With the PP you don’t have to adjust your asset allocation as you get nearer the date of needing the money, which is a good feature. Let’s say you’re using the Global Potato portfolio (for example) and you’ve reached a point in your investing timeline when it’s time to adjust your asset allocation to a more conservative one. This may force you to sell low as opposed to rebalancing to a fixed asset allocation which does the opposite. Could this cause you to get lower returns over the years? (since you would hit several of these timeline milestones in a 10-20 year period). Adjusting asset allocation due to investing timeline milestones seems like it could hold market timing risk, particularly when you have only a 10-20 year investing timeline and stocks have been in a bad period in the first so many years of that timeline.

    Your analysis showed that gold is not an inflation hedge. On the other hand, the PP has been shown to work very reliably, so does it matter that the theoretical underpinning posited by Harry Browne isn’t entirely accurate? Or that we haven’t seen significant deflation in Canada since the Great Depression?

  9. Clive September 10, 2011 at 8:19 pm #

    Using Justin’s data (thanks) with some inflation data added in, I estimate that had a person retired in January 2000, invested in a PP, and withdrawn 4% of the total fund value at the start of each year for living expenses then they’d have seen that income supported together with just under a 10% real growth in fund value over the last 11 years to the end of 2010. i.e. that income grew with (or in excess of) inflation.

    In contrast the Couch Potato’s fund value over the same period would be down -23% in real terms i.e. the 4% of total fund value as income drawn at the start of each year would have relatively declined in real terms year on year (generally) as did their fund value.

    Which would leave that CP investor having to close down a +43% gap to re-align to the PP.

  10. Canadian Couch Potato September 10, 2011 at 10:11 pm #

    @Chris: A couple of points about “cherry-picking.” Justin’s available data only went back to late 1979, so there was no conscious attempt to pick a favourable start date. More important, the Permanent Portfolio was created in the early 1980s, after Harry Browne lived through the tremendous gold returns of the 1970s. So including the 1970s in the PP results is actually more misleading.

    @Jon Evan and Pat: One of the ideas that seems to get lost in all of this talk of volatility is that the PP has only 25% in stocks and 25% in cash, while the Global Couch Potato has 60% in stocks. So of course the PP will have lower volatility. If you want to dampen the swings in any portfolio, you can always add more cash (or bonds), and allocate less to stocks.

    @Jon Evan: Don’t underestimate the emotional difficulty of rebalancing. Remember, the individual components in the PP are highly volatile, so in the 1990s, when gold was horrendous and stocks were shooting the lights out, you would have had to sell stocks and buy gold for five years in a row. After 2008, you would have had to sell your gold and buy more stocks in the middle of the financial crisis. Do you think you could have done this unemotionally?

    @Pat: Sure, there are 10-year periods where stocks or bonds do poorly—though rarely both at the same time. But there are just as many periods where gold does poorly. So I’m not sure why one would expect the PP to be more appropriate than a conventional balanced portfolio for a medium-term investment like an RESP. As long as the stock-bond mix is determined by your time horizon, it would be my first choice.

    @Clive: I don’t think there’s any question that conventional equity-oriented portfolios would have been soundly outperformed by the PP since January 2000. But now who’s selectively picking start dates? 🙂 I would also argue that 60% in equities is much more than most people would recommend for a retirement portfolio. A retirement portfolio invested primarily in fixed income would be doing just fine.

    If I had to sum up my opinion on all of this, it would be this way: The PP will outperform a balanced stock-bond portfolio during any period when gold does better than stocks, and will lag when stocks outperform gold. If you are an investor with a 20- or 30-year time horizon, which do you think will occur more frequently?

  11. Jon Evan September 11, 2011 at 12:02 am #

    @CP says: “If you want to dampen the swings in any portfolio, you can always add more cash (or bonds), and allocate less to stocks.”
    It is true that a pure fixed income portfolio has the least volatility but comes with the cost of poorer return. The PP lowers volatility yet it’s advantage over a mostly fixed income portfolio is that it obtains higher returns and so one gets both! Now, concerning the emotional difficulty of rebalancing you make a good point. I think the difference with the PP versus the CPP regarding emotion is that in the former usually one asset type is performing well and I think it’s emotionally easier to sell high that performing asset and buy a cheaper asset to rebalance like now it would be easier to profit from gold to buy cheaper stocks to rebalance in a PP. But with a CPP portfolio no asset type is presently performing! Neither fixed income nor stocks are doing well. It’s difficult to rebalance out the lower stock asset class when really the fixed income portion is making so little that to sell it is emotionally unappealing! Contrast that with the PP where presently gold is rallying and it is emotionally easier to profit take because few believe the gold rally will continue forever and one feels good to take a profit (so my PP friends tell me)! I’m thinking rebalancing is emotionally easier in a PP versus a CPP because there is greater diversification in the former and a greater chance for one asset to be performing well. As well, the PP has the important distinction of having gold which emotionally is always appealing to own ;)!

  12. Justin Bender September 11, 2011 at 2:03 am #

    @Chris – as CCP mentioned, I would have certainly given more data if it was available (I only had data for the DEX Universe Bond Index from December 1979). If you’re interested, please see below for more current values (December 1979 to August 2011):

    Global Couch Potato Portfolio:
    Annualized Return: 10.13%
    Annualized Standard Deviation: 8.83%
    Sharpe Ratio: 0.40

    Permanent Portfolio:
    Annualized Return: 8.81%
    Annualized Standard Deviation: 6.73%
    Sharpe Ratio: 0.32

    @Preet – if you’re interested in monthly or rolling returns, please let me know and I’d be more than happy to email you the data. I’ve run a “Preet Portfolio” as you had requested (i.e. 1/3 Gold, 1/3 DEX Long Term Bond Index, 1/6 S&P/TSX Capped Composite Index, 1/6 MSCI World Index) – see results below:

    Preet Portfolio:
    Annualized Return: 9.34%
    Annualized Standard Deviation: 8.95%
    Sharpe Ratio = 0.30

    Just for fun, let’s take gold out of the mix and replace it with cash (i.e. 50% DEX 30 Day T-Bill Index, 25% DEX Long Term Bond Index, 12.5% S&P/TSX Capped Composite Index, 12.5% MSCI World Index):

    Cash Heavy Portfolio:
    Annualized Return: 8.91%
    Annualized Standard Deviation: 4.64%
    Sharpe Ratio: 0.49

    …as one analyst once pointed out to me, “I’ve never seen a back-test I didn’t like” 😉

    @Raman and Pat – you’re very welcome!

    Please let me know if anyone has any other scenarios they would like to see modeled – I’ll try my best to put them together.

  13. Canadian Couch Potato September 11, 2011 at 10:06 am #

    @Justin: Many thanks again for all your work. I’ll note that the Sharpe ratio (a measure of risk-adjusted returns—the higher, the better) is higher for the Global Couch Potato than for the PP.

    But the highest of all is the Cash-Heavy Portfolio. Now that’s a surprise, though it can probably be explained by the long trend of declining interest rates during this period. All the benefit came in the first third of the sample: T-bills averaged 12% from 1980 through 1991, but only 4% from 1992 to the present.

    @Jon Evan: The whole point of this post was to demonstrate that the PP would not have provided lower volatility and higher long-term returns. It would have provided lower volatility and correspondingly lower returns.

    Funny how you (and many other commentators) constantly talk about how nothing is doing well in the current climate. Bonds (as measured by XBB) are up 5.37% year-to-date. They were up 6.13% in 2008 when “everything went down.” Indeed, they have not had a negative year in Canada since 1999. And yet everyone hates them. To me this is one of the great mysteries of investing.

    A simple 50/50 portfolio of stocks and government bonds can provide decent returns with quite low volatility. You don’t need to keep half your money in cash and gold to achieve this.

    Jon, you also mention that gold is “emotionally always appealing to own.” No, gold is emotionally appealing to own when it goes up 250% in seven years. Assets become somewhat less appealing when they lose value year after year, as gold did from 1988 through 2004.

    My goal with this series was not to denigrate the PP in any way. All I wanted to do was challenge some of the ideas that seem to be uncritically accepted, such as “gold is a hedge against inflation” and the PP provides “lower volatility with higher returns.” Neither of these is true. If you’re considering adopting the PP, just remember that it too will have rough patches, just as traditional balanced portfolios do. Those rough patches will come when gold is down and stocks are performing well.

    Use whatever strategy you’re comfortable with, but make sure you understand the risks so you won’t get blindsided when those bad years inevitably come.

  14. My Own Advisor September 11, 2011 at 10:24 am #

    Nice article Dan.

    Although this isn’t my own allocation, a 50/50 portfolio of stocks (say XIU) and government bonds (say XBB) are probably a good recipe for most investors to start working from, even from a Canadian-only perspective.

    Holding so much cash and gold, although I understood Craig’s rationale for doing so, is not necessary in my opinion – at least for my portfolio.

  15. Canadian Couch Potato September 11, 2011 at 10:44 am #

    @MOA: Thanks for your comment. For the record, XBB is 30% corporate bonds. For an all-government bond fund, you could use XGB or the
    RBC Canadian Government Bond Index Fund:
    http://funds.rbcgam.com/pdf/fund-pages/monthly/rbf563_e.pdf

    Adding corporate bonds should increase long-term returns, but government bonds have a stronger negative correlation with equities, which is what you want if your goal is low volatility. For example, government bonds were up about 9% in 2008.

  16. Daniel September 12, 2011 at 12:08 am #

    CCP thanks again for the great series on the PP, it’s good to see that it started such great dialogue.

    One comment I would have that might bring the two sides together is that Harry Browne advocated for a Permanent Portfolio that was, as he was fond of saying, for “the money that is precious to you” and the money you couldn’t afford to lose, Browne also supported a Variable Portfolio for speculating that could have anything in it as long as, to his mind, you accepted that you could lose that money.

    I don’t think it’s necessary having an “either/or” conversation as you can have both. For some people a PP might need to make up 100% of their investments, for others perhaps it could be 50% or 80%. In my situation I am currently saving towards a downpayment on a house in the next 3-4 years. As such the low volatility of the PP appeals to me and the smaller returns are not as much a concern (over such a short timeframe). However, once I’ve made that downpayment I think that I will likely follow a 80% PP, 20% VP split for my future investments. In that scenario my variable portfolio likely be 100% stocks as I would be seeking high long-term returns.

    The key would be to ensure that you are able to separate the PP from the VP and, as CCP stated, not be discouraged when gold lag stocks or vice-versa. In the VP, however, you could’ve moved from stocks to gold in 2009 perhaps (after the stocks had recovered) if you felt that stocks were still vulnerable.

    As Justin showed in his data the PP has a 8.4% CAGR and a 5.6% SD from 1980 to 2010. Any risk averse investor would be thrilled with such a portfolio.

  17. Preet September 12, 2011 at 1:05 am #

    @Justin – thanks so much for putting together the extra backtests. Without the Sharpe numbers, it’s hard to eyeball the risk adjusted comparison from a graph.

    Now if you could do a fore-test for the next 30 years… 😉

  18. rg September 12, 2011 at 2:06 am #

    Justin:

    How do you run these performance evaluations so easily? Is there software readily available to the public that can do it?

  19. Canadian Couch Potato September 12, 2011 at 8:21 am #

    @Daniel: I think Harry Browne’s Variable Portfolio idea is a good one for any investor. Charles Ellis and Burton Malkiel touch on the same thing in their book, The Elements of Investing. Many of us have a tendency to be impatient and may be inclined to tinker with our portfolios, and this allows you to indulge that without putting your serious money at risk.

    Note that the 5.6% standard deviation is an average of all the three-year rolling periods, not an annualized figure.

    I would really hesitate to recommend a PP-type portfolio as a short-term savings vehicle. With a time horizon of three to four years, I would think that a fixed-income fund with a duration of three to four years would be a much smoother ride.

  20. Sean September 12, 2011 at 11:57 am #

    The volatility of the PP is lower because of the high proportion of cash.

    The return of Global CP portfolio is higher because it has more stocks.

    If you put sugar in your coffee, it’ll become sweet.

  21. Justin Bender September 12, 2011 at 8:18 pm #

    @Preet – no problem, I’ll get started on my forecasting models right away 😉

    @rg – I use a program developed by Dimensional Fund Advisors (DFA) called Returns 2.2. By inputting monthly historical returns (in Excel format) for any available indexes or products, I am able to create hypothetical portfolios (in almost any currency), rebalancing them as desired. Historical standard deviation and correlation analysis are fairly straight-forward as well. I’m unaware of a program for the public with the same capabilities – perhaps another reader has some suggestions??

  22. Gaby A. March 26, 2012 at 6:50 pm #

    Late followup, I know, but found this link to a permanent portfolio mutual fund, in Canada. However, I can’t seem to find any info on it in Globefund (maybe looking in the wrong place?) Have you heard of this? It MAY be a dead page, but not sure.

    http://www.nbfinancial.com/en/andyfilipiuk/index.php?gr=3

  23. Canadian Couch Potato March 26, 2012 at 11:23 pm #

    @Gaby: This page has performance numbers up to the end of January, so it may well be current. But I don’t think it’s a mutual fund, it’s a portfolio created by the adviser: http://www.nbfinancial.com/en/andyfilipiuk/index.php?gr=1

  24. Gaby A. March 27, 2012 at 12:52 am #

    Okay, that’s why I can’t find any official history online. Thanks.

  25. Dave M November 7, 2013 at 5:18 pm #

    Realize this is an old post but I’d love to see how a 50% stock, 25% bond, 15% cash, 10% gold portfolio would compare. That’s the mix I seems to have become most comfortable with, but I’m not sure whether I should be.

  26. mark December 7, 2014 at 2:12 pm #

    This looks like a awesome portfolio and very interesting to read and discuss.

  27. mark December 9, 2014 at 10:34 am #

    I guess this PP not ideal in a open non registered account with the bonds being not sheltered? my TFSA is maxed at the moment.

  28. Shell May 23, 2015 at 10:33 pm #

    I’d love to see an updated post on the permanent portfolio. I’ve just opened my BMO Investorline account, am in the midst of transferring my mutual funds to sell them and take the one-time hit on DSCs, and buy my new ETF portfolio. Although I’m leaning toward one of the couchpotato recommended options, there’s some appeal in this portfolio to me. I’m 48 and behind on my retirement planning, though aggressively working to catching up in terms of contributions.

    I wonder if rather than 25% cash and gold, if I tweaked it down to 15% each cash and gold, 25% bond and 45% equity, would that give me a good middle ground? Thoughts?

  29. Tom August 17, 2015 at 9:19 am #

    I am also equally fascinated and terrified of the Permanent Portfolio (PP). I don’t think I could adopt the PP as it is, but one option I have been considering is to put the PP on a glide path starting with:

    Cash/GICs 13%
    BMO Long Federal Bond Index ZFL 13%
    iShares Gold ETF CGL.C 13%
    Vanguard FTSE Canada All Cap 20%
    Vanguard FTSE All-World ex Canada 40%

    then up to this at 65:

    Cash/GICs 17%
    BMO Long Federal Bond Index ZFL 17%
    iShares Gold ETF CGL.C 17%
    Vanguard FTSE Canada All Cap 17%
    Vanguard FTSE All-World ex Canada 33%

    then eventually up to this:

    Cash/GICs 20%
    BMO Long Federal Bond Index ZFL 20%
    iShares Gold ETF CGL.C 20%
    Vanguard FTSE Canada All Cap 13%
    Vanguard FTSE All-World ex Canada 27%

    Any thoughts? My alternative is to reconstruct a more standard glide path for the Canadian Couch Potato equity funds with a fixed 10% gold allocation thrown in for the coming zombie Armageddon.

    Maybe one could look at the cash/GICs/long bonds as a barbelled version of the VAB anyway. Then the only difference becomes a larger and growing allocation to gold?

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