September 22, 2012: Portfolio Frontiers

Let's examine the Permanent Portfolio (PP) through some interesting risk and return graphs. When investing, we are constantly attempting to balance risk and return. Rational investors prefer more rewards for a given level of risk, and less risk for a given level of rewards.

The following graphs illustrate how each asset class is risky in isolation, but becomes less risky when combined with the other elements. Remember, the PP is an equal split between stocks, gold, T-Bills (cash), and 30 Year Treasuries (bonds). The data used are annual nominal returns from 1972-2011. When looking at the graphs, it makes sense to look at the colored dot first, and see how approaching a PP (by adding the other asset classes) changes the risk profile.

With the exception of an all cash portfolio, adding the other PP asset classes added significant risk reduction. I find the cash graph to be the most interesting one, especially when compared to the others. To me, it highlights that there is no clear "right" level of cash for the PP. The trade off of risk vs. return is fairly consistent. I think an investor could tweak the cash level to help the PP meet their goals, holding more if they want less risk or holding less for the possibility of greater returns. I will probably stick with the 25% weighting, but I think tweaking it to one's own preference is perfectly understandable. Just be aware that totally removing cash makes you vulnerable to a Fed-induced recession (like 1981 with Mr. Volcker raising rates to extreme levels).

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