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 $1 million always keep $250,000 in cash, when its real return is unlikely to be 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 [since removed], 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.