Wouldn’t it be nice to not have to worry about investment decisions? The late Harry Browne, libertarian and investment adviser, thought so and proposed what he termed the Permanent Portfolio. His concept changed the way many looked at investing.

Browne’s Permanent Portfolio

Harry Browne created a portfolio designed to never need changing (except for periodic re-balancing due to valuation changes). It consisted of only four elements – stocks, gold, fixed income and cash – in equal proportions. Browne’s rationale was simple: in deflationary periods, cash and bonds were expected to perform well while stocks would perform well in more normal conditions. Gold would excel in inflationary conditions.

Using the permanent portfolio, Rip van Winkle would have made money during his prolonged nap.

Browne described his effort thusly:

“For the money you need to take care of you for the rest of your life, set up a simple, balanced, diversified portfolio. I call this a “Permanent Portfolio” because once you set it up, you never need to rearrange the investment mix— even if your outlook for the future changes. The portfolio should assure that your wealth will survive any event — including an event that would be devastating to any individual element within the portfolio… It isn’t difficult or complicated to have such a portfolio this safe. You can achieve a great deal of diversification with a surprisingly simple portfolio.”

So, how would this hands-off strategy have worked out had you applied it? It would have performed as intended according to the Finpage.blog. Using just four IShare ETFs to represent the four equal components of the Permanent Portfolio they tested the outcomes.

Finpage Simulation of the PP

Here are the four Ishare ETFs used to replicate the PP:

• iShares Core S&P Total Market ITOT
• iShares Gold Trust IAU
• iShares 1-3 yr. Treasury Bond TLT
• iShares 20+ yr.Treasury Bond SHY

Annual results for 12 years are shown below. The column at the right represents the overall Permanent Portfolio return.

The attractiveness of the PP is its relative stability of returns. There were only two small negative returns in the twelve-year time frame.

Returns are reduced from what an all equity portfolio would have yielded, but so too is volatility. Not shown is the maximum draw down. Maximum draw down is the percentage drop in wealth from the high point in equity to the low point. It represents the biggest drop from peak to subsequent trough. Were one invested only in the stock market (SPY) a maximum draw down of about 55% would have been incurred in the 2008 – 2009 sell-off. The Permanent Portfolio incurred a maximum draw down of 15%.

IShare ETFs were used to construct the portfolio but other comparable ETFs could be used. Vanguard has a family of funds that would be satisfactory. There is no need to stay within a particular family for your portfolio. So long as the components represent the underlying market segments above, it does not matter their origin.

Returns for the Vanguard family of funds were also shown in the Finpage article.

Diversification and Risk — The Key

Investment strategy involves more than just returns. If your objective were only to maximize return, then you would put all funds into the single asset you expected to outperform all others. Common stocks, as a class, have traditionally outperformed other asset classes. However, a strict return-maximizer would not invest everything into a stock index but would invest into the stock he expected to outperform all others.

We all are averse to risk. We assume risk to achieve higher returns. Diversification reflects the desire for returns but also the desire to limit risk. The proper amount of diversification for an individual depends on how he is wired. Do you prefer to eat well or sleep well? Most of us prefer both, but the world of risk and return does not cooperate willingly.

Risk aversion may be high or low for a particular person. All people are risk averse to various degrees. Regardless of what level or risk aversion we have, it tends to increase over our lifetime. We tend to be more tolerant of risk when young. This higher tolerance is not necessarily due to youthful exuberance, untamed optimism or foolishness. It is rational because bad outcomes at age 30 are easier to recover from than bad outcomes at age 60 or 70.

Time is a great healer for investors. Most investment mistakes can be addressed and corrected if they occur early in your life. Time also allows for career changes if necessary. Time correlates with energy. The young can work two jobs to get back on financial track.

Mistakes made later in life are harder, or impossible, to correct. Because mistakes or upset conditions are harder or impossible to correct with less time, it is rational to become more cautious with age.

The Permanent Portfolio Was Right But Not Permanent

Comments regarding increasing risk aversion with age makes a permanent portfolio problematic. If risk aversion changes over time, so too should your portfolio.Mr. Browne seems to imply such in this quote:

For the money you need to take care of you for the rest of your life, set up a simple, balanced, diversified portfolio.

Presumably you are not thinking in these terms when you are under forty or fifty years of age. While you may (and should) have goals, the farther away they are the less certain you can be of achieving them. Given one’s changing circumstances and the unknowns regarding economic conditions (especially inflation), it is unlikely you know the amount of money necessary until you are closer to retirement.

Mr. Browne’s portfolio is well-suited to the preservation of wealth. It is less well-suited for its creation.

Rather than a lifetime investment strategy, I suspect Mr. Browne was intent on showing that a single portfolio allocation could work regardless of the state of the world or markets. If that were his goal, he succeeded. He showed that a well-designed simple portfolio, with minimal oversight, could work. His work and the empirics it produced took much of the magic from financial advisors, hedge fund managers and the like. Browne’s efforts demystified much of investing.

The Universal Lifetime Portfolio

Browne’s Permanent Portfolio was permanent but it need not be. Marginal modifications can be made that retain its simplicity and increase its effectiveness.

The Universal Portfolio represents an approach nearly identical to that of the Permanent Portfolio. Like Mr. Browne’s work, it uses the same assets (plus one more) but modifies the risk components as one ages. Essentially, it represents three different forms of the Permanent Portfolio — one that is “risky” (young), one that is “normal” (middle-age) and one that is “safe” (later-age). Each of these is “permanent” for the period of time held.

The Universal Portfolio was inspired by Browne’s work. It is simplistic, passive and employs Browne’s philosophy. An article dealing with the Universal Portfolio will follow shortly.