The Best Asset Allocation Ever? The UK Permanent Portfolio - Pocket Risk


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The Best Asset Allocation Ever? The UK Permanent Portfolio

As a financial adviser you get judged on many metrics but chief among them is portfolio performance. Which client would want a financial adviser who routinely looses them money?

Depending on what you read asset allocation determines between 40%-100% of portfolio performance (The CFA institute has a great article on this over here). So whichever way you spin it, it’s pretty important.  Modern Portfolio Theory and the “Efficient Frontier” have left most of us with a sliding scale stock/bond fund split. 80/20 for people under 30 and the reverse for people well into their retirement.

We’ve left individual stock picking to the brave and clueless and yet when events like the financial crisis happen and clients loose 30-40% of their portfolio value in a matter of weeks we wonder if it was wise to put such a large amount of our portfolio in one asset class.

After all in our globalized world equity is equity. Is Lloyds Banking Group really uncorrelated with Credit Agricole. Enter the Permanent Portfolio devised by Harry Browne.

If I told you there was a portfolio that from 1972 to 2011 returned 11.4% annually, only had 3 down years (the worst being 4.8%) and had consistently beaten inflation would that make you sit up straight in your chair? How about the fact that during the worst financial crisis in the last 80 years 2008/2009 the portfolio returned 5.9% and 8.9% respectively while equity rich portfolios plunged.

Sure, past performance is no indication of future performance and I am sure I could back test any crazy portfolio mix to get a 1000% return but when you think about it logically the Permanent Portfolio has strong foundations.  Let’s dig in….

The portfolio holds an equal mix of UK equity, long dated Gilts, gold and cash. The portfolio is designed to take advantage of all the major cycles of the economy. Equity for prosperity, long dated gilts for deflation, gold for inflation and cash for a recession/depression.

At any one time the economy will be in one of these four phases ensuring at least a quarter of your portfolio is in the ascendency. Conversely, if there is a major stock market crash only 25% of your portfolio is likely to be affected.

What is remarkable about the Permanent Portfolio is its steady performance over the last four decades. It typically beats inflation by 3-4% without wild swings up and down. On a pure return basis it slightly under performs the traditional 80/20 equity bond split by about 0.3-0.6% but with a lot less volatility and down years.

You don’t get huge crashes and large upswings. It is steady and consistent. Despite these facts there are many objections to portfolio make up. Let me cover the three most common.

Question 1 – 25% Gold! Are you nuts?!?!

The premise of the Permanent Portfolio is that nobody knows what is going to happen in the future so you should be equally prepared for each outcome. For all we know a 70’s style economic malaise might be around the corner. Gold was a great asset to hold in the 70’s.

It’s true that gold doesn’t produce any dividends but it has been a store of value used for millennia. Why do you think central banks store billions in their vaults? What is special about gold is that it tends to appreciate in inflationary periods (few assets do that) and you can even use it as legal tender.

Question 2 – Where is the international equity allocation?

The portfolio is designed to meet inflation plus 3+% in your country of residence. If you add international stocks you start being subject to the economic conditions in a far away land in which you do not live. That being said many proponents of the Permanent Portfolio have a second allocation where they include some international stocks to take advantage of emerging markets or the biggest economy in the world (USA).

 Question 3 – How do I construct such a portfolio?

Simply index and leave it be. Here are a few options based on ease and expense.

UK Equity – Vanguard FTSE UK Equity Index Fund

Long Dated Gilts – Vanguard UK Long Duration Gilt Index Fund

Gold – EFT Securities – Physical Gold ETF

Cash – Bank savings account

If you want to learn more (and there is a lot more to learn) I encourage you to pick up a recent book about the Permanent Portfolio or visit the forum. If you still have doubts then read these two amazing forum posts where Modern Portfolio/Efficient Frontier supporters debate with Permanent Portfolio proponents. The posts are here and here. I’ve been studying the portfolio for the last year and I’ve been very impressed with its theoretical foundations and real returns.