The Purely Passive Permanent Portfolio

My nephew recently asked me to recommend a good book on investing for someone who was just starting to make contributions to his retirement plan.  Somewhat reflexively, I recommended Prof. Malkiel’s “A Random Walk Down Wall Street” as a good place to start.

I first read “Random Walk” in the 1980s and it was an eye-opener for me at the time. I was and continue to be a dyed in the wool Graham and Dodd fundamentalist. I had met and followed quite a few research analysts when I worked on Wall Street. Their opinions were coveted by institutional investors. The brokerage firms were justifiably proud if one of their analysts was named to the annual “All-American” institutional research team.

The random walk theory was not original to Prof. Malkiel. He popularized it in layman’s terms. He used a coin flip to create a trading pattern for a fictional stock and then attempted to have an analyst apply technical analysis to the resulting chart.  When the technician told him to buy the fictional stock he concluded that analysts could not accurately predict the future price of a stock, so why bother?

In Malkiel’s view, simple asset allocation with periodic rebalancing will outperform the overall stock market. The standard allocation, 60% stocks and 40% bonds will never increase as much in a bull market as stocks alone, but the bonds will buffer loses in a bad market.  Many people believe that this type of allocation is fine for investors over the long term.

Asset allocation requires the construction of a portfolio with non-correlated assets. The stock portion of the portfolio must be selected carefully or the entire purpose of the allocation will be defeated.  Prof. Malkiel currently shills for one of the large robo-advisors that does not perform asset allocation very well.

Correlation is a tricky concept. The idea is to purchase investments that are affected differently by shifts in macro-economic conditions.  A truly diverse stock portfolio should have stocks from at least 15 non-correlated sectors.  You cannot create a truly diverse portfolio by investing in large cap, small cap and emerging market funds or ETFs. The stocks in these funds are correlated to each other in too many ways.  Capitalization does not define a sector for allocation purposes.

If you buy an index fund or ETF such as the Standard and Poor’s 500 you get the average market return in good years and in bad years. If the market happens decline for the 3 years just before you need your money, such as the 3 years before you retire, your portfolio may be worth the same as it was worth ten years earlier. You may have earned nothing during the last 10 years that you were working.  That is ten years in which you could have easily doubled your portfolio’s value if you were 100% invested in income producing investments.

Many people want a portfolio that will give them “higher than average market returns with lower than average market risks.”  It clearly is something that can be accomplished but it takes work to get there.

You can beat any index or sector fund by identifying the “dogs” that are in it. Some of the stocks in an S&P 500 fund are not expected to do all that well in the next 12-24 months. Certainly if you constructed a portfolio of the 250 stocks most likely to do well and leave out the dogs, you should beat that index every year.

Eliminating the dogs requires analysis. Fundamental analysis works and is still the primary way in which most professional investors make their investment decisions.

The “problem” is that a lot of people do not think that anyone can actually analyze individual stocks and pick the winners over the losers. That, of course, is not true.

There are a great many securities analysts and portfolio managers out there who are more than competent. The problem is that the best investment advisors are mixed in with a lot of advisors who are more adept at sales than analysis.

Rather than take the time and put in the effort to understand investing well enough to choose a good advisor, people have fallen back on the idea that they can buy a few index ETFs, rebalance periodically and all will be well. That is the investment philosophy behind robo-advisors. It is an investment philosophy I call “cheap and stupid.”

This brings us to Harry Browne.  Browne developed what he called the “permanent portfolio” back in the early 1970s.  He introduced it to the world in a well received 1987 book called “Why the Best-Laid Investment Plans Usually Go Wrong”.

I came across this book when I started teaching Law and Economics in the early 1990s.  Much of the literature around Law and Economics at the time came out of the University of Chicago and had a very libertarian bias.  Browne was a Libertarian and later became the Libertarian Party candidate for President.

Browne’s book described the virtues of a diversified portfolio whose composition would stay constant year in and year out — permanent, in other words, except for annual rebalancing. Browne’s idea of diversification into non-correlated assets was different from what you might think and very different from the diversified portfolio that you will get with any robo-advisor.

Browne’s portfolio divided your funds into only four asset classes. The portfolio was equally divided between aggressive growth stocks, which do well in times of prosperity; gold which does well in times of inflation; long-term Treasury bonds which increase in price during times of deflation and Treasury bills which do well in times of tight money/recession.

Browne was a “gold bug”. He recommended that you hold the gold portion of the portfolio in bullion or gold coins. This was fairly common advice at the time.

At the time the book came out, Browne reported that the portfolio had produced an annual return equal to 12% over the preceding 17 years. Much of that return was due to the doubling and re-doubling of the price of gold. Gold was still pegged at $35 per ounce when the portfolio began.  The latter half of the 1970s was a period of high inflation which helped the price of gold to move up.

Browne’s permanent portfolio continued to do quite well in its original form until his death in 2006. A number of books and articles have been written about it and several people have modified it with funds and ETFs.

There is a mutual fund called the Permanent Portfolio fund (NYSE: PRPFX) which uses a modified permanent portfolio including real estate and Swiss Francs. The fund holds about $3 billion in assets. If you are really determined to be a passive investor and appreciate that those robo-advisors are a scam you might take a look at this fund.  You will discover that it has done quite well since 2006, when Browne died, until the present.

As always, I do not know anyone at this fund and no one has offered to compensate me in any way for recommending it.

Browne’s permanent portfolio has apparently produced positive results continually since 1970 through the present. It can do so because growth and recession, inflation and deflation are opposites and assets that perform well in each cycle are non-correlated by definition.

Will Browne’s permanent portfolio continue to do well, year in and year out?  It should. It represents asset allocation and diversification in its purest form.










Investing by yourself– Do you know what you are doing?

I always shudder when someone tells me that they are managing a few million dollars of their own money through a discount brokerage firm. Do they actually know what they are doing?

I randomly asked a few friends who have been investing on their own for years. How do you select the stocks that you buy and how do you know when to sell, I asked? The answers are not what you should expect.

No one professes to have a crystal ball. At the same time, few actually look at the financial information that companies file with the SEC. Professional investors all over the world use fundamental securities analysis to compare balance sheets between companies they are considering for investment. Self-directed investors rarely tell me that they even know how. It seems that a great many of the investment decisions that they make are emotional rather than rational.

More than one has told me that they get tips from a pundit on TV or a newsletter that they have come to respect. And how did they earn your respect, I ask? By being right more than wrong is the best answer I got but even that tells you nothing about the methodology behind the recommendations.

Remarkably, many people do not seem to trust the large wire houses and investment banks and the registered representatives that work for them. People use words like “crooked” and “conflicted” when they refer to these firms. If a research analyst at one of these firms writes a report regardless of quality, many people seem to dismiss them as dishonest.

More than one person told me that they invest in companies that have great new products coming out. You know that we believe that the fact of the new product is factored into the price of the stock as soon as the product is announced, I asked? For the most part, people, even those investing seven-figure accounts of their own money do not know what I am talking about.

The problem becomes more obvious when you ask: how do you know when to sell? Do you set targets or use stop losses? You really don’t think that I got a single affirmative answer, do you?

When I visit my financial adviser during the trading day, he may have half a dozen screens on; a financial news station with a live ticker; specialized screens following specific stocks that his clients own or which he is considering buying. He follows the market and “his” stocks, all day, every day. Is that how you manage your portfolio?

Even if you are well schooled in balance sheet analysis what do you know of the global markets, global economics and global politics. Forty years ago, Proctor and Gamble was a primarily domestic company. Today it operates in so many markets and has suppliers in so many others that its earnings can be affected by things that you cannot imagine, let alone identify and analyze.

As I got older, I came to realize that part of being wise is knowing what it is that you don’t know. It is true in life and especially in investing.

Ending fixed commission rates was a step toward market efficiency. The idea of discount brokerage firms where customers could purchase mutual funds and set up simple portfolios by themselves was likewise efficient.

The step from there to “do it yourself” with all of your money is a big one. Most self-directed investors do not have what it takes to avoid stumbling.

Emotional, irrational and uneducated investors contribute to market inefficiency. Every time that the market crashes more and more self directed investors come away with significant losses. Investing profitably is a lot harder than it looks. It takes time, attention, data and the knowledge of how to use that data.

If you do not think that you could pass one of the mid-term exams that I used to give to my students, hire an investment adviser.