February 23, 2012: Chaotic Interior

The Permanent Portfolio looks dead simple at first glance.

The equal weighting of 4 asset classes can make the PP appear as an oversimplified gimmick meant to appeal to lazy retail investors. In reality the PP is a very sophisticated investment strategy that many investors, even some professionals, lack the ability to execute.

Executing the Permanent Portfolio requires an extreme bar of rationality. One has to acknowledge their own fallibility regarding specific macro-economic outcomes, as well as recognize that ultimately the total portfolio value is what matters. One cannot simply view the risk of a single asset class in isolation to determine its merits for introduction into the portfolio.

I witness this "risk in isolation" mistake most often with investors' bond allocations, as some investors overly concentrate on the short end of the curve thinking it is the prudent option. After all, the price movements on the short end of the curve are less volatile than those wild 30 year Treasuries, right? Short bonds appearing less risky may be true in isolation, but that simple analysis is ignoring contribution to the total portfolio. Thirty year Treasuries significantly reduce the risk of many portfolios, especially the PP.

The charts below reveal the chaos that lurks beneath the PP’s exterior…

It takes discipline to focus on total portfolio value and methodically obey pre-determined rebalancing rules. It’s not for everyone, but the risk adjusted returns are incredible.

Chart notes:
These charts were constructed with data from Yahoo Finance and dividend reinvestment was assumed. The data is from 3/10/2006 through 2/23/2012.
  • Stocks- SPY
  • Gold- GLD
  • ST Treas- SHY
  • LT Treas- TLT

The vertical lines on the second chart indicate re-balancing points. When any asset class made up more than 35% or less than 15% of the portfolio, the PP was brought back to its 4 way split. This is standard PP procedure.

1 comment:

  1. That's a very succinct description of what probably gives PP investors the most trouble--assets in isolation and failing to appreciate the fact that the portfolio operates as a package.