Can 'permanent portfolio asset allocation' protect you from stock market fluctuations?
The dire stock market events of the last two years, and even the last ten years, have encouraged many less adventurous investors to flock to the Cautious Managed Sector of the unit trust universe.
Funds in this sector aim to be managed conservatively and are aimed at risk averse investors seeking capital preservation and a return above cash deposits. A typical fund will attempt to achieve this by holding a mix of shares and fixed interest securities (gilts and corporate bonds). The type of person who invests in such a fund is looking for peace of mind and to avoid the perils of an equity-only strategy. So seductive is the siren call of these 'low risk' funds that they were the most popular UK sector for the April 2009 ISA season.
Performance has been dire
So what has been the investment experience of these risk-averse investors? Well, over one year the average Cautious Managed fund has lost 12.4%. Over three years the average fund has lost 13.1%. Now call me old fashioned, but I fail to see anything remotely 'cautious' in that result. To put the result into context the average Global Growth fund (which are primarily equities) lost 14.1% over three years.
The reasons for this horrid performance are simple -- the asset allocation of most funds is quite simply not cautious. The Investment Management Association (IMA) 'restrict' these funds to holding a maximum equity exposure of 60% and at least 30% invested in fixed interest and cash. Well, sorry, but that kind of asset allocation is never going to protect you in times of financial disaster -- and that's precisely when you need protection.
The problem with the Cautious Managed sector, like many other asset allocation strategies, is that it pays too much attention to the correlation of financial assets (the probability of a declining asset being balanced by a rising asset) and too little attention to economic reality. Focusing on this reality means identifying assets that provide protection as the economy trundles its way through the four eternal cycles: prosperity, inflation, deflation and recession. I would also add another event: political crisis.
Quite by chance the other day, I came upon a little known American pundit named Harry Browne. Way back in 1981 he came up with an asset allocation strategy he called "The Permanent Portfolio". Put simply it holds assets in equal proportions that respond well to each of the cycles identified above.
Protection against all economic cycles
Most asset allocation strategies do not advocate holding more than 5% or maybe 10% in gold. In contrast, Harry Browne advocated 25%. This is his permanent asset allocation and the reasoning behind it:
- 25% in shares, preferably held in a low-cost fund. This ensures a strong performance during times of prosperity;
- 25% in gilts, which will perform well in times of deflation, and low inflation prosperity;
- 25% in cash, to hedge against tight money and recessionary cycles; and
- 25% in gold to provide protection in times of inflation and economic and political crisis.
I have read countless articles on asset allocation, but I have never seen anything remotely like this allocation recommended. Most financial whiz kids would say the allocation to shares is too low and the allocation for gold, with no dividend or interest, is too high.
Well, the proof is in the pudding so I crunched the numbers over 36 years to see if the portfolio would perform as well in the UK as it has done in the US.
Stable low-risk returns
The table shows the annual return of each asset, the average annual return and the compound annual growth rate (CAGR). All data except gold is from the Barclays Equity Gilt Study 2009. The gold data is the sterling series from the Gold Council. The data for shares and gilts includes re-invested dividends and interest.
| Year | Shares | Gilts | Cash | Gold | Average | Inflation |
|---|
| 1972 | 16.4 | -3.8 | 8.2 | 59.8 | 20.1 | 7.7 |
| 1973 | -28.1 | -8.9 | 9.7 | 68.8 | 10.4 | 10.6 |
| 1974 | -50.1 | -15.2 | 11.1 | 70.3 | 4.0 | 19.1 |
| 1975 | 149.3 | 36.8 | 11.0 | -12.0 | 46.3 | 24.9 |
| 1976 | 2.3 | 13.7 | 10.7 | 14.3 | 10.2 | 15.1 |
| 1977 | 48.6 | 44.8 | 10.7 | 6.9 | 27.7 | 12.1 |
| 1978 | 8.6 | 1.8 | 9.4 | 21.3 | 10.3 | 8.4 |
| 1979 | 11.5 | 4.1 | 12.2 | 100.8 | 32.2 | 17.2 |
| 1980 | 34.8 | 20.9 | 15.0 | 21.5 | 23.1 | 15.1 |
| 1981 | 13.6 | 1.8 | 12.9 | -13.6 | 3.7 | 12.0 |
| 1982 | 28.5 | 51.3 | 12.2 | 28 | 30.0 | 5.4 |
| 1983 | 28.8 | 15.9 | 9.6 | -2.9 | 12.9 | 5.3 |
| 1984 | 31.6 | 6.8 | 10.0 | 3.3 | 12.9 | 4.6 |
| 1985 | 20.2 | 11.0 | 10.8 | -19.4 | 5.7 | 5.7 |
| 1986 | 27.3 | 11.0 | 10.6 | 19.1 | 17.0 | 3.7 |
| 1987 | 8.7 | 16.3 | 9.7 | -1.8 | 8.2 | 3.7 |
| 1988 | 11.5 | 9.4 | 8.3 | -11.0 | 4.5 | 6.8 |
| 1989 | 35.5 | 5.9 | 10.7 | 10.1 | 15.6 | 7.7 |
| 1990 | -9.6 | 5.6 | 12.4 | 23.1 | 7.8 | 9.3 |
| 1991 | 20.8 | 18.9 | 9.3 | -1.5 | 11.9 | 4.5 |
| 1992 | 19.8 | 18.4 | 9.6 | 14.7 | 15.6 | 2.6 |
| 1993 | 27.5 | 28.8 | 4.1 | 16.1 | 19.1 | 1.9 |
| 1994 | -5.9 | -11.3 | 3.7 | -11.0 | -4.8 | 2.9 |
| 1995 | 23.0 | 19.0 | 3.9 | 3.1 | 12.3 | 3.2 |
| 1996 | 15.9 | 7.7 | 2.6 | -13.0 | 3.3 | 2.5 |
| 1997 | 23.6 | 19.4 | 3.1 | -19.0 | 6.8 | 3.6 |
| 1998 | 13.7 | 25.0 | 7.1 | -1.0 | 11.2 | 2.8 |
| 1999 | 23.8 | -3.5 | 5.1 | 1.0 | 6.6 | 1.8 |
| 2000 | -5.9 | 9.2 | 5.5 | 6.0 | 3.7 | 2.9 |
| 2001 | -13.2 | 1.3 | 4.7 | 3.0 | -1.1 | 0.7 |
| 2002 | -22.3 | 9.8 | 3.4 | 9.4 | 0.1 | 2.9 |
| 2003 | 20.2 | 1.6 | 3.3 | 11.1 | 9.1 | 2.8 |
| 2004 | 12.5 | 7.2 | 4.2 | -1.6 | 5.6 | 3.5 |
| 2005 | 21.6 | 8.4 | 3.9 | 27.2 | 15.3 | 2.2 |
| 2006 | 16.4 | -0.1 | 4.4 | 10.0 | 7.6 | 4.4 |
| 2007 | 5.1 | 5.2 | 4.8 | 23.9 | 9.7 | 4.0 |
| 2008 | -29.8 | 12.9 | 0.9 | 39.4 | 5.8 | 1.0 |
| CAGR '72 to '08 | 11.5 | 10.2 | 7.7 | 11.3 | 11.5 | 6.5 |
| Average '72 to '08 | 15.0 | 11.0 | 7.8 | 13.8 | 11.9 | 6.6 |
So, for the period from 1972 to 2008 the Permanent Portfolio method delivered the same compound annual growth rate (CAGR) as the equity portfolio but with none of the eye-watering falls. This assumes of course that you rebalanced your portfolio to 25% in each asset at the end of each year.
In fact, this method only experienced two minor down years in 1994 and 2001. In times of major crises, such as the early '70s and the last two years, gold has proved to be far more effective than fixed interest at boosting returns and maintaining wealth. And that's when you need protection most; ask any Cautious Managed Fund investor.
So go on, add some glitter to your holdings. You no longer have to purchase gold bars -- you can simply buy an exchange traded fund which tracks the gold price instead.
More on asset allocation and gold:
