Efficient Frontier 

William J. Bernstein

Wild about Harry

 

Harry Browne has experienced a renaissance of late, and a critical examination of his "permanent portfolio" teachs a lot about the nature of investing and investors.

First, some background. Harry, who died in 2006, was best known as the libertarian candidate for president in 1996 and 2000. However, he was also a financial advisor and radio commentator who began writing and speaking about personal finance in the 1970s. Originally a gold-bug newsletter writer, over the decades Harry’s thinking evolved along with advances in the empirical literature. He gradually came to embrace the gospel according to Fama, Bogle, and Malkiel so familiar to readers of these pages: timing the market, selecting securities, listening to gurus, and buying newsletters were mugs’ games. Talk about critical self-examination!

The more he delved into and personally experienced financial history, the more he became convinced of his—and anyone else’s—inability to predict the future. His conclusion: one’s personal wealth was far too precious to expose to the cruel mistresses of market timing and security selection; buy widely diversified low-cost mutual funds, especially if passively managed.

So far, so good. Harry then carried the logic of passive investing one step further. He assumed that three different economic scenarios threatened investors: inflation, deflation, and "tight money," the last of which he was a tad vague about, but best describes, I suppose, the shock therapy that Paul Volcker applied to the economy in the early 1980s. He thus prescribed a mix of 25% each of Treasury bills, long bonds, gold bullion, and stocks, reasoning that under any circumstance at least one or two of these assets would save your bacon. (This is not that far off from the asset allocation recommended by the Talmud: one-third each in land, business interests, and "reserves," the latter of which, in those days, meant silver.) If this seems a bit extreme today, realize that by the late 1970s, Harry was looking for a method of diversifying away from an all-precious-metals portfolio. Harry’s right-wing paranoid streak also led him to suggest spiriting assets abroad in case Uncle Sam decided to confiscate the nation’s nest eggs. Since I don’t have the legal qualifications to judge the orange-jumpsuit risk inherent in that aspect of his strategy, I won’t discuss it further.

From this point on, I’ll refer to his 25/25/25/25 mix as the "theoretical permanent portfolio" (TPP), where stocks = CRSP universe, gold = spot gold price, long bonds = 20-year government index, and T-bills = 30-day U.S. Treasuries. There is, though, nothing theoretical about this allocation; it’s eminently investable at minimum cost. The CRSP universe is nearly identical to a total stock market fund, the bonds and bills can be deployed individually as a "bar bell" or even more simply, if somewhat clumsily, as a 30-year ladder, and gold can be purchased as coins or, if you trust ETFs (I don’t), as GLD.

In many respects, this allocation is a thing of beauty. Not only does it provide some protection against all but the most dire of scenarios, but its correlation grid is one rarely seen in finance: four non-derivative assets populated entirely by near-zeros:

	Gold	Stocks	Long Bonds	T-Bills
Gold	1.00
Stocks	-0.16	1.00
Long Bonds	-0.20	0.05	1.00
T-Bills	0.02	0.05	0.11	1.00

For annual returns, 1964–2009.

How has the TPP done over the years? Not badly at all: when rebalanced annually since 1964, it has returned 8.53% per year with a standard deviation (SD) of 7.67%. For comparison, a 60/20/20 portfolio of stocks, bills, and long bonds returned 8.83%, but with a much higher SD of 11.25%. How about the bad times? In 2008, the TPP lost only 1.31%, versus a loss of 16.52% for the more conventional 60/20/20 portfolio. What about inflation? During the nine years between 1973 and 1981, inflation ran at an annualized 9.22%; the TPP returned 12.06% versus only 6.35% for the conventional portfolio, which also had a higher SD to boot.

Of course, we can juggle the numbers in multiple ways. Make 30% of the conventional stocks foreign (to make the conventional portfolio 42/18/20/20) and its return rises to 7.47% between 1973 and 1981. Further, value and small stocks tend to protect against inflation, since they do better than large growth stocks in such periods as they are more highly leveraged, and their balance sheets benefit from the inflating away of their liabilities. Below, I’ve plotted the return and SD of the TPP versus that of the small- and value- heavy DFA balanced strategies for the 1973–2009 period:

For a strategy that is stone-simple, does not require DFA funds, and has lower execution costs, the TPP does not do half badly. Realize, however, that it is a modest-return, low-risk portfolio and won’t buy many yachts. As Harry pointed out on multiple occasions, you get rich not by investing brilliantly, but rather by saving and safeguarding conscientiously.

So what’s the catch? In a nutshell, Harry’s strategy is a bit like communism: elegant in theory, but very difficult to execute in practice (no small irony, given Harry’s politics). It so happens that there’s a mutual fund that follows the TPP, the venerable Permanent Portfolio (PRPFX). Between 1983 and 2009, it returned 6.62% at an SD of 8.16%, versus 7.77% with an SD of 5.85% for the real TPP. The fund's lower return is easily explained by management fees, currently at 0.82%, but well in excess of 1% for most of its history. The higher SD is explained because the fund does not precisely follow TPP’s strategy; it currently holds 31% stocks, heavily weighted towards the energy and REIT sectors, versus 25% of the  market portfolio for TPP.  Consequently, it did worse  in 2008 than the TPP: –8.35% versus –1.31%.

Even so, in 2008 most investors would have been happy with PRPFX’s single-digit loss, and this attracted a lot of attention, as did the TPP.

PRPFX’s fund flows over the years serve as a good proxy for investor interest in the TPP. The turbulence surrounding the 1987 crash blessed the portfolio’s management, and its assets peaked out at nearly $100M in late 1989, a respectable size for that period. During the frothy 1990s stock market, however, investors abandoned the fund in droves, and presumably the TPP strategy as well. By late 2001, PRPFX languished at $52 million, a remarkable figure considering that between those two dates the return of the portfolio alone should have grown its assets by 71%, and total U.S. mutual fund assets had increased approximately seven-fold.

Since the 2008 crisis, investors have piled back into PRPFX with a vengeance, bloating its assets to over $6 billion. As you might expect, you can drive a small pickup truck between the fund's time-weighted returns (10.10% annualized for the 10-year period ending 7/31/10) and dollar-weighted returns (6.41%). Investment discussion boards now fairly bulge with TPP threads. For example, the typical topic runs a few dozen messages on the respected Vanguard Diehards board; one Harry Browne sequence weighed in at nearly 3,500 posts.

And therein lies the real problem with the TPP: because of its huge tracking error relative to more conventional portfolios, it attracts assets and adherents during crises, then sheds them in better times. There’s nothing wrong with Harry’s portfolio—nothing at all—but there’s everything wrong with his followers, who seem, on average, to chase performance the way dogs chase cars.

Investment success accrues not so much to the brilliant as to the disciplined, and the nature of the chosen strategy contributes mightily to this calculus. The very worst place an investor can find herself is, in the words of Mark Kritzman, "wrong and alone"; this is a near certainty at some point given the TPP’s huge tracking error relative to that of the overall market portfolio, approximated by a 60/40 mix of stocks and bonds. Thus, it will be nigh-impossible for even the most disciplined investors to adhere to the TPP in the long run. (And lord knows, most investors are unable to stick to even a 60/40 portfolio.)

Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out. Harry certainly did so by moving away from gold and into poorly performing stocks and bonds in the late 1970s. Sadly, this is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently—effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%.

Many investors currently have the Harry Browne portfolio. The 1990s stampede of assets out of PRPFX and the more recent stampede back in suggest that few will turn out to have the Harry Browne right stuff.

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