Permanent Portfolio

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The Permanent Portfolio is a portfolio construction theory devised by free-market investment analyst Harry Browne in the 1980s. Browne refined and simplified the portfolio in the mid 1990's. Using a variation of efficient market indexing, Browne stated that a portfolio equally split between stocks, precious metals, government bonds and treasury-bills would be a safe and profitable portfolio in any economic climate. [1]

Objective

The primary objective of the Permanent Portfolio (PP) is to achieve moderate returns while suffering very little volatility.

Secondary objectives include minimizing investing expenses, counterparty risks, and maintenance; avoiding paid advisors; and safeguarding part of the portfolio against total collapse of the local economy.

The portfolio uses a total return strategy, so returns are realized through a combination of capital appreciation, interest, and dividends.

Premise

An underlying premise of the PP is that the economy fluctuates between four conditions:

  1. Prosperity
  2. Recession
  3. Inflation
  4. Deflation

At times one condition may predominate; at other times multiple conditions may be in effect, or the economy may be in a period of transition from one condition to another. While it is often easy to identify economic conditions in hindsight, identifying conditions in the present may be very difficult or even impossible.

Another key premise is that the future is unknowable. As a consequence, it is impossible to make accurate predictions about future economic events. The PP philosophy is agnostic toward which economic conditions, sectors, or individual securities may predominate in the future. It holds assets suitable to profit from and defend against all four conditions at all times.

The four-condition analysis is consistent with Austrian business cycle theory.

Asset allocation

The PP asset allocation involves four assets, held in roughly equal proportions. Each asset relates to a specific economic condition; when a condition predominates, its corresponding asset ought to rally due to macroeconomic forces.

  • 25% stocks for prosperity
  • 25% cash for recession
  • 25% gold for inflation
  • 25% long term bonds for deflation

Stocks, gold, and long term bonds are considered volatile assets. Their market price fluctuates wildly as economic conditions change. Each enjoys an inherent form of leverage, as described below.

Rebalancing

Due to market fluctuations, the value of the four components of the portfolio will fluctuate away from precise 25% allocations. For the portfolio to work as intended, all four assets must be present in substantial quantities at all times. Yet, maintaining an allocation of exactly 25% in each asset would require daily transactions, incurring unacceptable commission and tax expenses. Thus, a balance must be struck.

Conventional advice is to adopt a strict policy of keeping each asset's value within 10% of its target allocation. As each asset's target allocation is 25%, this means that each asset must be kept to an allocation between 15% and 35%, commonly known as a 15/35 band.

When an asset moves outside its band, a rebalancing event occurs. The asset above 35% should be sold down to 25%, and the proceeds used to bring lagging assets back up to 25%.

Stocks and prosperity

Prosperity is characterized by an expanding economy and a healthy financial system free of serious inflation, deflation, or credit scarcity. Under these conditions businesses can expand quickly and stock prices generally rally. Corporations typically finance capital expenditures with debt, allowing them to expand faster than would otherwise be possible. This creates leverage, and so stock prices generally rise faster than the rate of underlying economic expansion.

In keeping with the premise of not predicting the future, the stock allocation is held in a total market index fund.

Cash and recession

In PP terms, recession refers to a tight money supply. In other words, market participants are surprised to find that they have less cash available than they had planned. These conditions tend to coincide with periods of shrinking GDP, unemployment, falling corporate earnings, and a bear stock market, which are alternative definitions of recession. However, the PP defines a recession as a period of an unexpectedly scarce money supply.

During a tight-money recession, cash is in desperately short supply and so becomes significantly more valuable. Many have no choice but to liquidate assets to raise cash (store inventories, real estate, personal possessions, stocks) and those holding cash can buy these things at fire-sale prices.

Unlike the three volatile assets, cash is not inherently leveraged; its market price does not upswing as sharply under recession as, for instance, gold does during inflation. Consequently cash functions as more of a buffer than a growth asset within the portfolio. This aspect of the portfolio could be improved by discovery of an asset that reliably rallies in price during recessions; however, no such asset is known.

While cash is unleveraged and thus reacts less forcefully than the other three assets, this is only a minor drawback since recessions are inherently self-limiting. A surprisingly small money supply can only exist briefly. Either money is created, or people adapt to the new reality which ceases to be a surprise. Hence it is unlikely that a period of recession, as defined here, could last more than 1-2 years.

It is important that the securities held as PP cash hold their value and remain liquid during a severe monetary or banking crisis. Cash must be comprised of securities that are highly liquid and with as little credit risk as possible. The only vehicle that meets those criteria is very short-term government debt; in the US, Treasury bills (T-bills). For matters of convenience, cash is often held in a money market that holds only T-bills.

Variants

Longer-duration

Some PP investors choose to hold some or all of their cash allocation in government debt of a slightly longer duration, say 1-3 years. The added duration tends to increase the interest rate earned on the cash allocation, in exchange for introducing a slight amount of interest rate risk.

Gold and inflation

Inflation occurs when the supply of money expands faster than the demand for money. When inflation happens, the value of units of currency decreases relative to things that might be bought with that currency, and so prices tend to increase. Central bank policy seems to favor a slow and steady inflation, and so inflation rates of 0-5% per year are commonplace. In PP terms, inflation refers to a severe inflation or hyperinflation, where prices rise unpredictably and very quickly, perhaps 10% or more per year. Inflation of that magnitude disrupts business and confuses the valuation of capital investments and securities.

Gold is an element whose physical properties make it well-suited to serve as money. It has been recognized as a store of value throughout nearly all of recorded history and among nearly all human cultures. It is a de facto, internationally-recognized form of money. Under a severe inflation, prices on all things rise, including gold. Due to rising prices, people seek to trade currency for hard assets; this tends to cause a mass exodus from currency into gold (among other things), which pushes the price of gold higher.

In our present monetary system, the supply of fiat currency is much larger than the supply of monetary metals including gold bullion, which creates a leverage effect when money flows between currencies and the gold market. This causes the price of gold to be highly volatile, on both the upside and downside.

Conventionally, the entire gold allocation is held entirely in physical 1 oz. gold bullion coins under the direct control of the investor. Some PP investors choose to hold part or all of the gold allocation in gold ETFs. ETFs tend to be cheaper and more convenient to transact, but involve counterparty risk and an ongoing expense ratio.

See also:

Bonds and deflation

Deflation is the opposite of inflation. Under deflation, the supply of money is smaller than demand for money, and prices tend to decrease. With prices decreasing, interest rates fall rapidly. New bonds are issued with lower interest rates, which make pre-existing bonds with higher interest rates more valuable. The longer the duration of a pre-existing bond, the more enticing it becomes; so the bonds that appreciate most are those with the longest duration.

Thus the PP holds long term (25-30 year) bonds. The long duration of the bond creates a leverage effect where those bonds' prices appreciate or depreciate by a multiple of the drop or rise in interest rates.

Deflations, sometimes labeled depressions, wreak financial havoc leaving many institutions bankrupt. So it is important that the bonds in a PP have as little default risk as possible. The borrower with the least credit risk is the federal government, and so the PP holds only sovereign (Treasury) bonds.

The uncertainty caused by deflation tends to create a flight-to-safety impulse, where investors exchange riskier assets for safer ones. As government bonds are one of the safest securities available, their prices tend to be bid up during deflations. This amplifies bonds' price appreciation during deflation, although the effect is secondary to the appreciation caused by falling interest rates.

See also:

Variable Portfolio

The PP program includes an option to create a Variable Portfolio (VP). An investor is free to invest VP funds however they wish, possibly violating PP strictures, subject to two rules:

  1. Money that you cannot afford to lose must be placed in the PP.
  2. PP assets may never be transferred into the VP.

Together, these rules prevent an investor from facing financial ruin due to poor outcomes in the VP.

Potential uses for the VP include

  • Holding a stock index fund, making the portfolio resemble a more conventional stock-heavy portfolio.
  • A hybrid approach, where a large VP is invested in a different strategy such as dividend growth stocks.
  • Moving between the four PP assets to speculate on macroeconomic changes.
  • Buying individual stocks.
  • Holding REITs as an alternative to direct real estate equity.

There is no constraint on the balance between the PP and VP. Taken to an extreme, a split of 10% PP and 90% VP would be consistent with the PP plan, provided that a total loss of the 90% VP could be tolerated.

A VP is by no means required, and many PP investors choose to forgo it.

Outside the US

The original books describing the PP were written by US authors for US audiences, so they described the PP assets in terms of US securities.

However, in a radio show (TODO: add reference), Browne explained that the economy referenced in the four-condition analysis is a variable which refers to whatever economy the investor participates in. For an American, economy means the US economy, while for a German, economy means the German economy, and so on.

So, the four assets may be described in a location-independent way as:

  • a total stock market index for your home country
  • cash in your local currency, invested in short term government bills/bonds
  • gold bullion
  • long term bonds issued by your home country

For the US, this yields the usual allocation of total US stock market, T-bills, gold bullion, and long term US Treasury bonds.

A Japanese investor would have

  • Japan stock market index
  • yen (short term Japanese sovereign bonds)
  • gold bullion
  • long term Japanese government bonds

and a UK investor would have

  • UK stock market index
  • GBP (short term UK bonds)
  • gold bullion
  • long term UK government bonds

The same pattern ought to work in any country that has a reasonably diversified domestic stock market, short term government bonds, and long term government bonds.

An investor in a country that lacks those prerequisites might consider building a PP based on the US, or whichever developed nation is most influential on the local economy.

Backtesting localized PPs through periods of economic crisis have shown that the PP concept is robust to severe economic problems. Backtests have shown that a localized PP would have worked as designed through the Japanese lost decade and Icelandic financial crisis.

See:

History

The PP was conceived by Harry Browne and Terry Coxon and first presented in the book "Inflation-Proofing Your Investments" in 1981. That book described a more complex conception of the PP, involving a wider range of asset classes and a framework for allocating them according to individual tastes. For instance, an investor concerned about inflation might overweight gold, while an investor sensitive to volatility might overweight cash.

In 1982 the PRPFX mutual fund was started. The fund's composition resembled an inflation-oriented asset allocation described in "Inflation-Proofing Your Investments," which was natural given the inflationary environment of the early 1980s.

In 1998 Browne wrote "Fail-Safe Investing," which described a simpler conception of the PP, as shown here. The palette of asset classes was simplified to four, and the asset allocation policy was unequivocally to hold the four classes in equal proportions. In 2003 Browne released an updated version of the book, sold electronically through his website.

From 2004 to 2005 Browne hosted an investment-themed radio show, covering the PP and related topics.

Circa 2008 Craig Rowland publicized the PP on his own Crawling Road blog, and on other blogs and forums. Around that time an "epic" thread started on the popular Bogleheads forum, which attracted significant new attention to the PP among the Internet investing community.

In 2012, Rowland and J.M. "MediumTex" Lawson published "The Permanent Portfolio: Harry Browne's Long-Term Investment Strategy". The book collects and summarizes PP material in a single cohesive volume, and revisits implementation issues that changed after Browne's final PP book was published in 2001.

Implementation

Specific individual funds

See the spreadsheet in this forum thread and this forum thread on cash options.

Emergency cash

The PP tends to experience low volatility, and includes a substantial 25% cash allocation. As a result, some PP investors choose not to hold a separate cash reserve or "emergency fund" as is often suggested for investors using other strategies. If a PP investor has an unforeseen need for liquidity they can use part of their cash allocation, and follow the usual rebalancing rules if necessary.

401(k) lemonade

The PP can be difficult to implement in 401(k) plans. Stock index funds and money market funds are frequently available, but suitable bond funds are rare and gold is unheard-of. When an investor's 401(k) is less than half of their total portfolio, and the plan has an acceptable stock and cash fund, the 401(k) can house the cash and stock allocations and the rest of the portfolio can go in more flexible accounts. However often the 401(k) is the majority of assets, or the plan has no acceptable cash fund, in which case implementing a PP is impossible.

In such cases the lemonade modification to the PP could be used (as in "turn lemons into lemonade"). In theory, the cash and bond allocations, which are short- and long-term treasury bonds respectively, behave equivalently to intermediate term treasury bonds. So the cash and bond allocations could be merged into one large intermediate term treasury allocation:

  • 25% stock
  • 25% gold
  • 50% intermediate Treasury bonds

Intermediate Treasury bonds are often available in 401(k) plans. A plan that has suitable stock and intermediate bond funds could house 75% of a PP, leaving only the gold to be located elsewhere.

If an intermediate Treasury fund is unavailable, a different intermediate bond fund could be substituted. Total bond market index funds are widely available and could fill this role. However, any deviation from Treasury bonds adds credit and liquidity risk (as discussed in the cash and bond sections above), so this should be considered a last resort.

Note that the description above uses the dangerous phrase "in theory." In a severe recession or deflation the PP may need to rely on the unique properties of cash or long term bonds respectively to carry the portfolio. Intermediate bonds may not function adequately in that case. So, the lemonade variant should only be used as a temporary measure until the 401(k) assets can be rolled over into a more flexible account and a pure PP can be implemented.

Fund-of-funds

There are three funds that implement a complete multi-asset Permanent Portfolio: PRPFX, PERM, and Cor Capital Fund. Conventional wisdom is to implement the PP using mutual funds for stocks and cash, and to buy gold and bonds directly, in order to minimize expenses and counterparty risk. With that disclaimer, a single-fund PP may be appropriate to minimize transaction expenses in small portfolios or for investors that are unable, unwilling, or disinclined to maintain the individual assets themselves.

PRPFX

As stated in the History section above, PRPFX was incepted in 1982 and uses an asset allocation that is older, more complex, and more inflation-hedged than the newer 4x25 allocation. As of June 2012, the fund's Fact Sheet lists the allocation as

  • 20% gold
  • 5% silver
  • 10% Swiss francs
  • 15% real estate and natural resources stocks
  • 15% growth stocks
  • 35% Treasury bills and Treasury bonds

The stock and bond allocations are actively managed, not indexed. PRPFX is an open-ended mutual fund. Shares may be purchased through a broker or directly from the fund itself. Its expense ratio is relatively high at 0.77% circa June 2012.

PERM

The Global X Permanent ETF (PERM) is an exchange traded fund (ETF) that uses a PP-like strategy. PERM's fact sheet lists its allocation as

  • 20% gold
  • 5% silver
  • 25% long term Treasury bonds
  • 25% Treasury bills
  • 12% Large Cap US stocks
  • 5% REITs
  • 5% natural resources stocks
  • 3% ex-US stocks

This is not identical to 4x25 but is more similar than PRPFX' allocation. Its expense ratio is 0.49% which is lower than PRPFX', but still significantly higher than a DIY multi-fund implementation which is typically less than 0.20%.

Cor Capital Fund

The Cor Capital Fund is a mutual fund based in Australia that tracks an orthodox equal split among Australian stocks, Australian bonds, Australian cash assets, and gold. Its expense ratio is relatively high at 0.75% circa October 2013 and its minimum initial balance is $500,000 which may be out of reach for ERE-sized portfolios.

References

[1] investopedia, definition

External links

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