At Sound Mind Investing, we’ve been spending a lot of time thinking about this question: Where does one invest when everything looks expensive? And when economic uncertainty is especially high? And when the traditional safe haven, bonds, have never been as overvalued as they are today?
We found part of the answer we were looking for in the Permanent Portfolio (PP).
What is the Permanent Portfolio?
Developed in the late 1970s by investment adviser Harry Browne, the Permanent Portfolio was designed to weather ever-changing economic conditions, delivering solid results along with significant downside protection.
Browne’s simple solution was to divide a portfolio into four equal investments: stocks, bonds, gold, and interest-earning short-term investments such as U.S. Treasury bills (i.e., “cash”). These asset classes were selected because each would excel under a different economic extreme, with at least one of the four likely to be in synch with the current economic environment.
Other than rebalancing periodically, this four-part mix would always stay the same – hence the name Permanent Portfolio.
How did it perform? From 1982-2011, such a portfolio gained roughly 8.2% per year. While the S&P 500 gained 11.1% per year, it did so with significantly greater volatility and risk.
And that’s one of the PP’s greatest strengths: respectable returns without the wild ride often delivered by the market. In fact, over the course of three decades, the PP had only two years of negative returns, and the worst (2008) was just -7.2%. This type of smooth ride has a lot of appeal to investors who lost more than 30% in stocks during 2008 alone, not to mention three consecutive years of losses between 2000-2002.
Improving on the Permanent Portfolio
The Permanent Portfolio seemed to offer much of what we were looking for. However, with apologies to Harry Browne, there also seemed to be two significant issues.
First, while our goal was to create an investment strategy that appeals to safety-conscious investors, the PP was even more conservative than most people need. Allocating one-fourth of your portfolio to cash may have made sense in the late 1970s when that would have earned 15% in a money-market fund. Today, cash earns virtually nothing, so keeping a quarter of your portfolio there is a non-starter.
The second problem has to do with human nature. The PP has looked especially good over the past decade or so, due to stocks being weak while bonds and gold soared. But there have been long stretches when the PP lagged the market badly.
For example, Stocks gained more than 20% for five straight years from 1995-1999, while the PP earned more than 11% only once! We’ve watched investor behavior very closely over the past 22 years, and know how few have the willpower to stick with an approach like this when stocks are crushing the returns of their PP.
While a pure application of the PP wasn’t going to work for us, it did spark our thinking about designing a strategy consisting of asset classes that are especially not correlated to each other. The breakthrough came when we started testing what happens when we own only the asset classes showing momentum at that particular time, rather than owning all of them all the time. By applying an Upgrading-like momentum screen on top of the Permanent Portfolio idea, we emerged with a simple but powerful strategy we call Dynamic Asset Allocation (DAA).
Our roster of asset classes eventually expanded to six: the PP’s original four, plus foreign stocks and real estate. Using these six asset classes, we applied a momentum screen at the beginning of each month, identifying the three asset classes we wanted to be in and—perhaps more importantly—the three we wanted to avoid. Each month we re-ran the screen and adjusted our holdings as required.
The results were very impressive to say the least.
Winning By Not Losing
Thorough back-testing of the strategy, in which we used past market data to see how DAA would have performed, showed a 13.6% annualized return over the past 30 years—significantly better than the S&P 500′s 11.1%.
That’s great, but it’s not even the main story.
One of the most important issues we were trying to address was to find a replacement for bonds as a safe haven for risk-averse investors. If boosting a portfolio’s bond allocation was no longer going to provide the safety from future market storms, we needed something else that would. That’s the real value of this new strategy.
DAA has only had one losing year, a loss of -6.6% in 1990. And, when we looked specifically at 2000-2002 and 2008, while stocks were plummeting and investors were full of panic and fear, DAA investors would have been breathing easy. DAA outperformed the stock market while being 42% less volatile! That’s nothing less than stunning.
The key to DAA’s success is winning by not losing. By dramatically reducing losses, the strategy is able to come out ahead in the long run.
Needless to say, we are very excited about this new strategy.
To get the current DAA investment recommendations and discover all that Sound Mind Investing has to offer, sign up for a web membership. At just $9.95 per month and the ability to cancel anytime, it is an extremely low-risk/high-reward investment in your financial future.
By Mark Biller
Mark Biller is Sound Mind Investing’s Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.