There are always temptations for index investors, and the continuing ascent of gold is a particularly tough one to resist. The market gurus are scaring investors away from both stocks and bonds, while the shiny metal just keeps climbing. That might be one reason why the almost forgotten Permanent Portfolio—which in some ways foreshadowed the Couch Potato strategy—is starting to regain its lustre.
The Permanent Portfolio was created in 1981 by Harry Browne, an American investment adviser, writer and politician who died in 2006. It’s dead simple. You put your money into four equal buckets: stocks, long-term government bonds, cash, and yes, gold. In the 30 years since Browne first wrote about it, the Permanent Portfolio has delivered an annualized return of more than 8%. Even since 2000, the start of the worst decade for stocks since the Depression, it has hovered around that 8% mark. No wonder it’s attracted a new generation of disciples.
One of the most articulate of these is Craig Rowland, a start-up and technology consultant in Portland, Ore. Rowland, who hosts a forum about the strategy at CrawlingRoad.com, encountered the Permanent Portfolio about five years ago. “My background is computer security,” he says. “So I always test ideas by trying to break them. When I looked at traditional index fund portfolios, there were periods when they broke—they had significant declines, or extended periods where they did not have real returns over inflation.”
Rowland says that Browne hit on a better way to diversify. “He didn’t pick the four asset classes because they had some past positive or negative correlation with each other. He picked them based on economic cycles, and that was really the genius of his approach.” Browne argued that economies alternate between prosperity and recession, inflation and deflation. So he chose stocks for periods of prosperity, cash to keep you afloat in a recession, gold as a hedge against inflation, and long-term bonds as a safety net in times of deflation. And since you can never tell what’s on the horizon, Browne recommended holding equal amounts of each asset all the time, rebalancing when the allocations stray well off target.
The idea has held up remarkably well. Rowland backtested the portfolio to 1972 and found that in almost every year, if one or more of the asset classes got clobbered, another picked up the slack. Both stocks and bonds were negative in inflation-plagued 1977, but gold was up over 23% and the portfolio returned 5.6% for the year. In 1988, gold fell by almost 16%, while equities were up 18%. And in the chaos of 2008, when stocks plummeted 37%, long-term bonds returned 33% and the portfolio eked out a 1.9% gain.
Many investors like the idea of the Permanent Portfolio, but wonder why there’s so little allocated to stocks. Rowland asked the same question when he first picked up Browne’s books. “When I read about the 25% in gold, I thought he was nuts. And then I read about the 25% in long-term bonds and I thought he was really nuts. But you can’t look at the assets in isolation: you have to consider the portfolio as a whole.”
Here’s what Rowland means. Stocks, gold and long-term bonds can all have double-digit gains or losses in a single year. But look what happens when you combine them: over the last four decades, the portfolio would have lost money exactly twice (in 1981 and 1994), and both of those declines were less than 4%. “It’s like in chemistry,” Rowland says. “By themselves, sodium is explosive and chlorine is toxic. But if you mix them together you get salt, which is benign. It’s the same thing with this portfolio.”
It would be easy to adopt the Permanent Portfolio using exchange-traded funds. You might split the stock portion between the iShares S&P/TSX Capped Composite (XIC) and the iShares MSCI World (XWD). You can get long-term government bonds through the BMO Long Federal Bond (ZFL) and gold with the iShares Gold Trust (IGT). For the cash component, a savings account will do fine.
I’m not ready to adopt the Permanent Portfolio myself, but I do think it can teach index investors some valuable lessons. The first is the value of sticking to your asset allocation regardless of market conditions. Trying to predict whether this will be a great year for stocks, or whether interest rates will go up, or whether gold is overvalued—it all amounts to guessing. Many people predicted 2010 would be a terrible for the Permanent Portfolio, yet it went on to return over 14%.
The other lesson is that discipline is crucial to any strategy. In the 1990s, stocks returned over 20% five years in a row, while gold lost money every time. How many people would have rebalanced from a huge winner to a massive loser for five straight years? After the carnage of 2008, would you have the nerve to put more into stocks? The Couch Potato strategy presents similar challenges, and you need to be prepared for the short-term pain that rebalancing can cause.
Rowland the computer security specialist says he still hasn’t been able to break through the Permanent Portfolio’s firewall. “I’ve looked into every criticism, because it’s my own money at stake. But I sleep like a baby following this strategy.”