by J.M. Lawson and Craig Rowland

Simple, safe and stable: These are the three tenets of the Permanent Portfolio, a strategy invented by the late Harry Browne to help investors grow and protect their life savings no matter what was going on in the markets.

Over the last 40 years, the strategy has returned 9.5% compound annual growth. The worst loss, a drop of 5%, occurred in 1981. In 2008s financial crisis, the portfolio was down only around 2% for the year. We think thats pretty impressive for a strategy that appears so startlingly simple on the face of it.

The Basics

The basic premise of the Permanent Portfolio is this: The economy is always transitioning between four states. If you own an asset that can deal with each of those states, you will achieve powerful diversification. Harry Browne identified those states as:

1. prosperity,
2. deflation,
3. recession and
4. inflation.

What assets and allocations are best to deal with these economic states? Simply:

• 25% stocks (prosperity)
• 25% bonds (deflation)
• 25% cash (recession)
• 25% gold (inflation)

You buy these assets all at once and hold them at all times. While the Permanent Portfolio is simple, it is not simplistic. It actually reflects a sophisticated understanding of economics. Lets explore this.

A Passive Approach

The Permanent Portfolio does not time the market and is completely passive. There is no need to analyze charts, follow market gurus, track moving averages or anything of the sort. This is a good thing because weve never seen any of those methods work reliably anyway. Adopting a strategy that treats the future as uncertain and deals with it realistically best serves investors. The net result is not only a portfolio that has low turnover (which means lower taxes), but also has very low volatility, which means lower chance of catastrophic losses (and stress).

Figure 1 shows the performance of the portfolio from 19722011. Notice that the swings in assets individually had little impact on overall portfolio volatility each year.

Why It Works

Lets talk about the four economic environments to understand how the diversification works.

Prosperity: Good for stocks

Prosperity is good for stocks as the economy is firing on all cylinders. During this time, it is not unusual to see double-digit gains in this asset. Indeed, owning the stock market is the best way to take advantage of the power of companies to innovate and produce wealth. The 1980s and 1990s showed the power of the U.S. stock market, as average returns were well over 10% a year (and closer to 15% in many cases). An investor who didnt have stock exposure during those years missed huge profits.

Yet, the stock market can also encounter extended periods of very poor returns. The 2008 crash caused a nearly 40% decline, capping off a very bad decade of the 2000s. With high inflation, stocks can also have a hard time keeping up. This happened in the 1970s, where stocks had a decade-plus of negative real returns after inflation took its share.

Deflation: Good for bonds

We define deflation as a situation where market interest rates are falling steeply. Usually this is the result of fallout of a credit-fueled asset bubble, such as the real estate collapse in 2008 or the Great Depression of the 1930s. Falling interest rates are very good for high-quality U.S. Treasury long-term bonds. In 2008, the overall market was down almost 40%, but Treasury long-term bonds were up almost 30%.

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Recession: Good for cash

A recession, in the Permanent Portfolio sense, is a sharp deliberate raising of interest rates by the Federal Reserve in an attempt to stop inflation. Last time this happened was in 1981, when thenFed Chairman Paul Volcker enacted policies to bring the prime rate above 21%. In this condition, no asset really does well, but cash can act as a buffer while things settle out. Cash in the portfolio also is useful for emergency expenses and opportunistic rebalancing as the other asset classes are swinging in value. Cash also is a great diversifier emotionally because no matter what your portfolio is doing, you always have a stable anchor to tap if you need it.

As with bonds, though, high inflation is not a good thing for cash. While the asset can usually tread water as interest rates rise, the reality is that cash simply wont generate a high enough rate of return to reliably beat high inflation. In many cases, cash can lag inflation each year and result in negative real returns.

Inflation: Good for gold

Gold is the most controversial asset in the Permanent Portfolio. People either love it or hate it. We try not to create a conviction for this asset because its just a tool for our purposes.

The fact is that gold provides strong diversification against the inflation risks inherent in stocks and bonds. Inflation in this sense can be the double-digit mess we had in the 1970s that eroded wealth over a decade. Or it could be the malaise of the 2000s with anemic stock returns but constant inflation, resulting in zero real returns for many investors. Yet over these same periods, gold turned in great returns that could be harvested and used to grow wealth. History provides clear lessons on why we think owning gold in a portfolio is a good idea.

Golds weakness, though, is that in a prosperous market investors simply wont want to own it. If confidence in the dollar is sound because the economy is booming, investors will see no use for gold and its price will fall. Also, in a deflationary market, it could be the case that a rising dollar can make the price of gold go down as well.

The lesson?

While in hindsight many think they can predict the markets, the reality is that we simply dont know what will happen. Narratives such as gold is in a bubble, stocks are the best asset for the long run and rates on bonds cant go any lower have nothing to do with how markets actually perform. The truth is that no one knows.

Against this backdrop of uncertainty, what is the fate of the Permanent Portfolio investor who holds all four asset classes? Well, since he has nothing riding on any particular market prediction and has placed no bet on any particular outcome, he is ready for whatever economic conditions happen to show up. The bonus is that he also enjoys peace of mind because there is nothing the market can do that he isnt already prepared to handle.

The Assets

The Permanent Portfolio holds four core assets:

25% Stocks: A broad U.S. stock market index such as one of the Dow Jones Total Stock Market (TSM) indexes or an S&P 500 index. Why? Because indexing will beat virtually all actively managed stock trading strategies over time.

25% Bonds: 100% U.S. Treasury long-term bonds with maturities between 20 and 30 years. U.S. Treasury long-term bonds are regarded as default-free and the safest to own for U.S. investors. The U.S. government can always tax or print money to pay bondholders (many other bond issuers cant do both). This means when the markets are behaving very badly, the safety of the U.S. Treasury bond will dominate. It will be the last man standing.

25% Cash: 100% U.S. Treasury bills are the safest way to hold cash. They do not have credit risk, default risk, FDIC insurance risk or other risks that bank certificates of deposits (CDs). corporate bonds and even municipal bonds have. They are also the most liquid investment you can hold. In a market panic youll always be able to access your cash. Dont discount this feature: In 2008, some prominent non-Treasury money market funds froze redemptions and even lost significant value.

25% Gold: Physical gold bullion stored securely in a custodian account at a bank in your name. As a form of money, gold is often used in the markets when the U.S. dollar is having problems. Note that the portfolio holds gold bullion, not gold mining stocks. There is a difference in that gold bullion is not affected by the same impacts that could influence gold mining companies. For extra safety, this asset can also be held outside the country where you live for geographic diversification against political impacts, or natural and manmade disasters that affect the markets. Exchange-traded funds ( ETFs) can be used, but they are not as safe as custodial accounts in the event of a serious currency crisis.

Implementation

Implementing the strategy can range from very simple to more involved. At the simplest, there are two funds available that implement the basic ideas. The first is a mutual fund called the Permanent Portfolio fund (PRPFX). which has been in existence since the early 1980s. It implements an earlier version of the strategy, but has robust moderate growth. In 2012, a new exchange-traded fund from Global X also showed up, called the Permanent ETF (PERM). This new fund sticks more to the 25% allocation split and trades for a lower cost than PRPFX. Performance figures for PRPFX are shown in Table 1. along with a comparison fund and the average performance for balanced domestic funds.