Crisis Investing

2020-05-28

Exactly four years ago I wrote a post entitled "Investing for the Rest of Us", in which I discussed the permanent portfolio investing method, invented by Harry Browne. The permanent portfolio has two additional benefits that I've come to fully appreciate only this year: uncorrelated assets and forced rebalancing.

First, the four permanent portfolio assets - stocks, long-term bonds, gold, and cash - are not highly correlated. If one of them goes down, it's likely that one or two of the others will go up. For instance, if the stock market crashes as happened two months ago, bonds are likely to go up in price (because central banks have cut interest rates) and there's a strong possibility that gold will as well (because investors tend to flee to physical assets in times of uncertainty and volatility). This means that your portfolio doesn't experience wild swings in value; as a result, you're less likely to panic and sell everything.

Second, if one of the assets declines or advances far enough, the permanent portfolio method will force you to rebalance. This means that you tend to buy low and sell high. Specifically, when one of your assets goes above or below your rebalancing bands, you buy and sell enough of each asset to get back to 4x25%. (Harry Browne set the rebalancing bands at 15% and 35%, but Gobind Daryanani's paper "Opportunistic Rebalancing: A New Paradigm for Wealth Managers" indicates that 20% and 30% are more profitable.)

We can illustrate these principles with a simplified example. Let's say you have a portfolio of $400,000 with $100,000 each in stocks, bonds, gold, and cash. If stocks experience a 40% decline, the equities portion will be worth only $60,000; but it's quite likely that bonds and gold will go up, let's say by 10% each. If you'd been 100% invested in stocks your portfolio would be worth $240,000, but because you've spread your savings across four relatively uncorrelated assets your portfolio is worth $380,000. In addition, the rebalancing rule now kicks in: stocks are only 16% of your portfolio, so you'll sell a portion of your bonds and gold to buy stocks and get back to 4x25%. Reversion to the mean indicates that stocks are likely to increase in price again, and you've bought them on sale. (Sure, stocks might continue to go down or bonds and gold might continue to go up, but the future is uncertain and you're probably not smart enough to guess the tops and bottoms of these price trends.)

The permanent portfolio is like a self-correcting gyroscope, which removes the emotions of fear and greed from your financial decision-making. You might think you're wise or self-disciplined enough to do that all on your own, but it's much easier to follow a well-defined method like the permanent portfolio.

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