The personal website of Matt Henderson.
23 April 2013
A friend contacted me recently with concerns about the fact that his Permanent Portfolio is down about 2% since he started investing about eight months ago.
Let's start by looking at why the portfolio is down. Here's a chart of the performance of the portfolio's four asset classes during the past six months:
Stocks are up 9.6%, long-term bonds are up 1.6%, cash is flat at 0.2%—and gold suffered a crash, down 17.7%. Over the past six months, the overall portfolio is down 1.7%. (And this is especially painful to experience during a period in which the stock market has been on a tear.)
What should we think about this? Should we be surprised? Should we be concerned?
It's important to remember why the particular asset classes of the permanent portfolio were included in the first place. Three of them—stocks, long-term bonds and gold—were chosen because of their volatility and their relationship (or lack of) with each other. To get the maximum diversification effect through rebalancing, we want assets which are both volatile and uncorrelated.
So one of our asset classes is experiencing volatility. And it's experiencing negative volatility during a period when another of our asset classes (stocks) is doing very well.
That's not surprising; in fact, it's to be expected.
What matters is how the portfolio performs over our investment horizon. We are long-term investors (if we needed our funds in the short term, we would have them in cash.) Let's look at how the permanent portfolio has done over the past five years:
Stocks are up 16.6%, long-term bonds are up 32.5%, gold is up 52.2% and cash is flat at 1.3%. Over the past five years, the overall portfolio is up 25.7%.
The permanent portfolio is by no means "mainstream"; in fact, with respect to most mainstream portfolios, it will experience a large _tracking error_—meaning it will likely do well when others are doing poorly, and likely under-perform when others are doing well.
That characteristic makes it a dangerous portfolio for investors who are undisciplined or uncomfortable in standing alone.
William Bernstein is one of the best investors around. When he reviewed the permanent portfolio, he picked up on that specific aspect—that while it's a good investment, it will be difficult for people to stick with, because in general people don't want to be "wrong and alone".
Here's what Berstein wrote:
And therein lies the real problem with the Permanent Portfolio (PP): because of its huge tracking error relative to more conventional portfolios, it attracts assets and adherents during crises, then sheds them in better times.
There's nothing wrong with Harry's portfolio—nothing at all—but there's everything wrong with his followers, who seem, on average, to chase performance the way dogs chase cars.
Investment success accrues not so much to the brilliant as to the disciplined, and the nature of the chosen strategy contributes mightily to this calculus. The very worst place an investor can find herself is, in the words of Mark Kritzman, "wrong and alone"; this is a near certainty at some point given the PP's huge tracking error relative to that of the overall market portfolio, approximated by a 60/40 mix of stocks and bonds. Thus, it will be nigh-impossible for even the most disciplined investors to adhere to the PP in the long run. (And lord knows, most investors are unable to stick to even a 60/40 portfolio.)
If you invest in the permanent portfolio, you should expect:
As investors, we need to remain disciplined and steadfast, remembering why we're investing in the PP in the first place—a history of long-term stability and performance, consistent with its design.
I hope you enjoyed this article. If you'd like to learn more about the basics of investing, I wrote a book that introduces the fundamentals, and can be read in about an hour's time.
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