Permanent Asset Allocation

Short run Intermediate Long Run
Nominal Real Nominal Real Nominal Real
Stocks + + small – big + 0
Bonds 0 0 0 + 0
Cash + + +
Gold 0 + small +
Short run Intermediate Long Run
Inflation Real Inflation Real Inflation Real
Stocks + 0 – small – big + +
Bonds 0 0 + +
Cash + 0 + 0 + 0
Gold 0 + small – small + 0

(Note: Nominal = Real + Inflation)

This article is meant to tie up some loose ends, and suggest the outline of what might be a clever way to do asset allocation.? Who knows?? At the end, there might be a surprise.

I’ve done two articles recently on the effects of inflation expectations and real interest rates on two asset classes in the short run — gold and stocks.? Tonight, I want to extend that two directions, to bonds and cash, and whether the effects aren’t different in the long run.

First, bonds in the short run.? Interest rates rise, bond prices fall.? Interest rates fall, bond prices rise.? Doesn’t matter whether that comes from real rates rising, or inflation.? That’s pretty simple, because most bonds are mostly interest-rate driven.

Second, cash in the short run.? Leaving aside financial repression, for the most part cash assets return in line with inflation.? Cash is simple… so what happens in the short run is also what happens in the long run.

Okay, now let’s lengthen the time horizon.? In the long run, gold keeps pace with inflation, nothing more, nothing less.? Bond returns rise if interest rates rise over the long term because of higher reinvestment rates for cash flow, and again, it doesn’t matter whether that comes from inflation or real rates.? Opposite if interest rates fall.

Think of 1979-82: by the time bond yields were nearing their peak levels, bond managers were making money in nominal terms with rates rising because the income from the coupons was so high, and it set up the tremendous rally in bonds that would last for ~30 years or so.

In that same era, stock multiples collapsed.? But eventually stock prices stopped going down even with competition from bond yields, because the earnings yields were so large that book values roared ahead, supporting prices.? That also set up the tremendous rally in stocks that would last for 18 years, until it finally overshot, giving us the present lost decade-plus.

But high rates, whether from inflation or real rates, presage high future bond and equity returns.

One nonlinearity here: in the intermediate-term, rises in real rates kill stocks, but rises in inflation nick stocks.? Why?? Inflation may improve nominal revenues at the same time that it raises the cost of capital, but rises in real rates indicate capital scarcity, raising the cost of capital with no increase in revenues.

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Harry Browne proposed a “permanent portfolio” back in 1981, composed of equal portions of cash, bonds, gold, and stocks.? Reading about the idea in Barron’s in the late 1980s, I did not think much of the idea.? I think differently now.? After my last few articles on related issues, mentioned above, I realize that each of the four asset classes react differently to macroeconomic stimuli in the short run, with a lot of overshooting.? A mean-reverting strategy has a lot of power in this context, and it is double-barreled, in that it lowers volatility and raises returns.

My clients will receive the full details on this as an asset allocation strategy, but my readers have enough from this that if you want to do a little work you can figure this all out yourselves.

All that said, I am surprised at how well the strategy works.? Too easy, and easy strategies rarely work.

8 thoughts on “Permanent Asset Allocation

  1. Though it’s obviously not an equal-weighted portfolio with these four passive exposures, all you need to do is look at Permanent Portfolio (PRPFX) to see how well the idea generally works. That fund has more aggressive stocks on average than an index, also contains other precious metals besides gold, uses a healthy dosage of Swiss francs, and also has real estate exposure. But the ideas are generally the same, and the performance for a LONG time has been spectacular. Not nearly as great in the 90s obviously, but still compelling.

    1. The guy who runs the Permanent Portfolio mutual fund has semi-abandoned Harry Browne’s ideas to follow his own. Over similar periods, the original idea, simple as it is, has done better, and can be easily implemented with SPY, GLD, TLT and SHY.

      1. I haven’t seen a report of how HB’s mix has done in the last few years (except 2011). His website has performance through 2003. Clearly, from the 80s through 2003, the HB portfolio generally did better than PRPFX. PRPFX did better in 01, 02, and 03, and with the new PM starting in 03, I don’t know if that trend has continued or whether the simple HB mix has come out on top. Either way, I’ve become a fan over the last few years of these simple yet effective asset allocation techniques that have largely withstood the test of time better than a mean-variance optimized mix of assets.

  2. good post. i’m convinced that the Permanent Portfolio is best way to go for passive investors. Going back to 1972, the Permanent Portfolio boasts an average annual return of nearly 10%. It’s biggest down year in the last 40 years is just under 4%. In 2008 it was actually up 1 or 2%. Astounding indeed.
    Here is a link to an informative blog on the PP is: http://crawlingroad.com/blog/. Just learned that he is going to write a book on the subject- updating Harry Browne’s classic.I am just wondering why more people do not know about it? I wrote a post on this a few months back on my own blog: http://takingmoneyseriously.blogspot.com/2011/09/fire-your-money-manager-hire-yourself.html

    1. I became familiar with crawling road in my research process. I score the biggest down year around 7%, with the largest 12-month drawdown somewhat larger, but yes, the return figure has been around 10% since 1970, and the volatility very low compared to many other strategies that I have seen.

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