Some may think that this allocation sounds very different than what they’ve seen elsewhere, and some questions will probably pop up in your mind.
-Only 25% in stocks, that’s seems very little. What good reasons are there to invest only so little in stocks?
-Long term bonds prices tend to drop significantly when interest rates rises, and interest rates have nowhere else to go but up. What good reason is there to own long term bonds now instead of short term bonds?
-Gold is a non-yielding asset, it seems to be just a yellow metal with few industrial use and valuable only as jewellery. What good reasons are there to invest 25% in gold?
-What good reasons are there to keep as much as 25% as cash in low yield Money Market Funds and not invest them for higher yield?
-Stocks and bond prices move in opposite directions, and since there are equal amount of stocks and bonds, what good reasons are there why their price movements will not cancel each other and provide zero growth?
-There are only 4 assets, what good reason is there to believe this is a well diversified portfolio?
Notice how I phrase these questions. If you ask the questions this way, then you may have a more open mentality and be glad to discover that there are good reasons for such asset allocation. First, to answer these questions, do not just look at how each asset will perform individually. Next, learn to look at how each asset performs relative to one another and affect the portfolio as a whole during a particular macroeconomic cycle (prosperity, inflation, recession, deflation). You probably need some help to answer these questions, so for some insights to the answers, you may visit http://www.bigfatpurse.com/2012/06/championing-the-permanent-portfolio-as-a-fail-safe-investment-strategy-craig-rowland/.
Here I also attempt to provide brief summary of the answers.
In a prosperous economy, smart money flows into stock markets which provide higher growth potential than bonds and commodities, causing stock prices to rise quickly. On the other hand, stock markets can also experience decades of no growth, such as the 1970s and 2000s where the US stock market hardly grows during the decade. Also, from 1989 onwards, the Japanese stock market has experienced long term negative growth, so 25% in stocks would reduce exposures in case these major negative events occur. We all think stock markets will always rise, yet we will not know exactly when the next lost decade of stock market growth or recession will happen.
When there is deflation, smart money flows into long term bonds which is now more valuable than cash and commodities. Choosing long term bonds is because during deflationary periods, long term bond prices rise faster that short term bonds and can hence do a better job of covering for losses due to drops in commodity and stock prices.
In inflation, smart money flows into commodities where prices are being push up due to sudden increase in monetary supply or currency depreciation acts of central banks and governments. Gold is a commodity and is a store of wealth for several thousand years, even now. Notice that central banks around the world are currently hoarding large amounts of this yellow metal. Gold as a hard asset performs well during monetary inflation and serves to preserve fortune especially when central banks are printing more paper money. In extreme cases when a country's government fail and their paper money depreciates in value drastically or disappears, gold will still retain its value and can be exchanged for the goods and currencies of other nations.
In recession, commodity and stock prices move lower and smart money exit these assets and increase their cash pool to retain their fortune, and await for better time when they can use their cash to buy these assets more cheaply. Some smart money flows into bonds during recession. Cash also comes in handy for investors for sudden big expenses and the 25% cash can also be used as emergency fund so there is no need for investore to set aside another emergency fund.
Although long term bonds and stocks prices generally move in opposite directions, a rising asset will normally rise faster than the falling asset. To understand this simply, let's think that 30-years long term bonds and stocks have similar volatility in their price range movements, which in fact they do have similar price volatility. It is easier for people to start a new position to chase after a rising asset (stock), hence more people buy and rising asset (stock) price rise faster. It is more difficult to close a losing position in a declining asset (bond), as some people hold on to positions hoping for asset (bond) price to turn around, hence price of declining assets drops more slowly than rising assets, in general. This is why a simple 50% stocks and 50% bond portfolio can still provide positive annualised growth, in the long run.
A well diversified portfolio avoids big losses and provides growth in different economic conditions, and this is what Permanent Portfolio does, and does it better than many other portfolio allocations. The simple 4 assets class also makes it simpler and cheaper to manage the portfolio, as there are only 4 assets to manage, so this portfolio will be simpler to implement for many retail investors compared to portfolio with more assets. The simple 4 way 25% split among the 4 assets are not arbitrary. The reason for the equal split is so that in each economic cycle, the asset that performs best in that cycle will have enough mass to bring up the entire portfolio and provide portfolio growth. If one is to decrease the percentage of an asset, for example if we reduce long term bonds to 10% of portfolio (while we have 30% gold, 30% stocks, 30% cash) then in deflationary times, the 10% of long term bonds will not grow enough to offset the drops in 30% of stocks and 30% of gold. Since we cannot predict when long term bonds, stocks, gold and cash will perform particularly well, we maintain equal amount of each of these assets so that each of them can do its job when the time comes for them to carry the load. The past performance speaks for itself that such equal 4 way split of the assets works in Permanent Portfolio. For other types of portfolio, such equal splits among assets may or may not work as desirably as in Permanent Portfolio. It all depends on the characteristics of the assets in the portfolio and what they are used for.
Who are the smart money? They are institutional investors, pension fund managers, mutual fund managers and hedge fund managers in the world who are responsible for about 90% of the total volume of trades in all the investment markets everyday. For Permanent Portfolio investors of the 4 assets, we aim to let smart money with their kings of fund managers, armies of analysts and mountains of wealth move the prices of these assets and grow our portfolio year after year while we enjoy some fruits of their labor and enjoy our lives.
So you may have one more important question, how did Permanent Portfolio strategy performed in the past? Here you can see the past 40 years track record of Permanent Portfolio strategy in the U.S.A: http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/ . This result shows the kind of long term portfolio performance I am looking for: to avoid big losses in value which could scare me to close the portfolio prematurely and take heavy losses, to grow my portfolio consistently over the years, and require very little time to manage. For in depth understanding of the answers, please read Harry Browne’s book “Fail-safe Investing” and also look at all posts about Permanent Portfolio at http://crawlingroad.com/blog/category/permanentportfolio/ .
For someone new to investing, It may take you a few days or a few months to understand the inner workings of Permanent Portfolio strategy and prove to yourself that this is the portfolio investment strategy for you. It may be well worth the effort for you to learn indepth reasons about how and why Permanent Portfolio works, even if it is only to learn about how investment assets and economic cycles are related.