After the last couple of years, many investors are wondering if there’s an investment strategy that could have avoided all that volatility while still earning the returns they’ll need to retire on time. This Marketplace article discusses the “permanent portfolio” strategy developed by the late investment adviser Harry Browne. The portfolio arguably has the best long-term track record of producing returns that have been higher than the stock market with minimal volatility. The strategy’s secret? Old-fashioned diversification taken to a whole new level. To paraphrase: The Office‘s Michael Scott: it’s like diversification on acid.
The strategy consists of simply dividing your portfolio equally into stocks, long-term government bonds, cash, and gold– then re-balancing it each year. This portfolio was able to produce a 9.7 percent compounded rate of return from 1972-2008, beating the stock market’s 9.3 percent return over that same time period. More impressively, the portfolio’s worst year was a 3.9 percent loss in 1981 compared to the 36.7 percent loss of the stock market in 2008.
How did it do this? While stocks provided the long-term growth, the allocations to the other three asset classes acted to stabilize the portfolio during periods when stocks didn’t do so well. Browne characterized those times as deflationary, inflationary, or tight money recessions. In addition, re-balancing forces you to sell whatever asset classes are doing well while they’re high and to buy the lower performing asset classes while they’re low.
For example, during a deflationary recession like the one caused by the financial crisis in 2008, stocks and real assets like real estate and commodities, plummet in value. However, government bonds do well in deflation as the Federal Reserve cuts interest rates to revive the economy. Although most investors have some bonds in their portfolio, most have either too many corporate bonds, which can fall in value during a deflation due to lower bond ratings, and/or too many short term bonds, which don’t appreciate enough to offset the losses from stocks. On the other hand, Browne’s long-term government bond allocation rose 33.4 percent and led his portfolio to a 1.9 percent positive return that year.
Some economic forecasters fear that the same loose monetary policy that produced a strong bond market that year could eventually lead to the second type of bad scenario: higher inflation, seen in the 1970s. A traditional portfolio of stocks and bonds would have performed poorly during that decade as the stock market remained essentially flat and bond values fell. This is where the gold allocation would have helped to produce healthy returns for the overall portfolio. In fact, gold’s strong performance over the last few years have led many to believe that we may already be heading for higher inflation. If the Federal Reserve tries to prevent this from happening it could bring about the third type of economic storm: a tight money recession in which higher interest rates cause stocks, bonds, and real assets to all lose value like in 1981-1982. That’s where the cash allocation would kick in. Fortunately, unlike inflationary or deflationary periods, tight money recessions never last very long.
The biggest downside is that the portfolio has never been tested in a period where interest rates are rising from such historic lows. The last time we saw rates spike up was in the 1970s, when the drop in bond values was buffered by the high interest rates on both the cash and bonds in the portfolio. There will be no such buffer when rates eventually rise again.
So what do you think? Is the “permanent portfolio” hyper-diversification worth considering?