The second topic in the series on Retirement Portfolio will focus on portfolio diversification.

I will share my thoughts on 2 specific retirement-portfolio ideas, (a) the Permanent Portfolio and (b) the 7Twelve Portfolio.

Each satisfies the following two basic requirements, that I feel are essential for self-directed individual investor:

1. offer broader diversification (as compared to those offered by the Buffet Portfolio)
2. is easy to construct (and maintain) using ETFs that are available from at least major one brokerage firm at zero transaction fees

In this post, we will exclusively look at the Permanent Portfolio.

The Permanent Portfolio

My interest in Permanent Portfolio stemmed from my desire to answer the following question:

Is it possible to construct a virtually risk-free retirement portfolio?

Let me first clarify the term “virtually risk free” in the context of the problem of home-purchase and down-payment.

Many of us have at some-point in our lives worked diligently towards building up enough cash reserves for a down-payment on the house.

The median home price in Seattle is now $722,000, which means, a 20 % down-payment requires cash saving of $144,000. Quite a chunk of change!

The fear of loosing out on this principal forces us (and rightly so) to park this sum of money in a regular bank savings account  (should you choose to hold savings account in BoA, the rate of return is meager 0.01 %).

Virtually risk free in this context means, high probability of investment not decreasing below principle (even in the scenario of black swan events such as the financial crisis of 2008) with a non-zero probability of earning more than 0.01% on the investment.

Virtually risk free can be converted to absolutely risk-free by making the simple choice of parking money in a FDIC insured online savings bank that offers on the order of 1 % rate of return in current market conditions. I think this is the especially the right choice if the time frame for purchase is less than a year.

Not withstanding the above scenario, Permanent Portfolio is an investment vehicle that has the potential to offer virtually risk-free returns on investment that are significantly above the nominal savings rate offered even by online banks.

Permanent Portfolio (also called the Simple Portfolio) was described at length by by Harry Browne in his book on personal investing titled: Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.

The idea is to design a portfolio (or an investment vehicle) that is immune all macro-economic environments, i.e., inflation, deflation or recession.  In his book, Harry Browne suggests the following break down for constructing a Permanent Portfolio (PP)

• 25 % in US stocks – which, usually provide great returns in times of prosperity
• 25 % in physical gold bullion – which, is traditionally considered to be a good hedge against inflation
• 25 % in US treasury bills- which, prosper in a deflationary market
• 25 % in money markets- which is invaluable when money supply is tight as in times of recession.

Rebalancing is done annually.

It is not hard to imagine that one of the above four market environments, namely: prosperity (US markets since Mar 2009 ), recession (Financial crises of 2007-2008), depression (stock market crash of 1929) or inflation (double digit price inflation of 1970s), usually prevails at any given moment in time.

Barring some strange circumstances, almost always one or two of the above four asset types will save the day financially in any market scenario. This increases the likelihood that not only the principal  remains intact but at the same time by having a presence in the markets, there is an increased likelihood of getting decent investment returns over a sustained time period.

Let us find out if there is empirical evidence to support the idea that PP is a “virtually risk-free” vehicle for parking our hard-earned money.

Let us begin by constructing a PP, using ETFs. Since, my objective was to choose a time-period that covers at least one-black swan event, i.e., 2008 financial crash, I chose to construct PP out of ETFs that  were created before the 2008 and have lowest expense-ratio.

Table below provides a summary of the ETFs that I chose to construct the PP.

PP	Ticker	Expense Ratio %	Tracking Error	Total Assets $	Inception Date	Commission Free
25 % Stocks	ITOT	0.03	0.04	51.3 B	5/24/2001	Fidelity
25 % Treasury	TLT	0.15	0.22	7.2 B	7/22/2002	Fidelity
25 % Money Market	SHY	0.15	0.03	11 B	7/22/2002	Fidelity, TD Ameritrade
25 % Gold	IAU	0.25	0.73	8.9 B	1/21/2005	None

Let us now look at how the PP performed over the years.

The chart below summarizes, the annual returns for the PP  over 1 year (HP1) and 2 year (HP2) holding periods respectively, starting from 2005 through present day. 

Note: Annual dividend are not taken into consideration in the analysis presented below.

For year 2005, HP1 implies, the PP was created on 1st day stocks for all ETFs were available and the portfolio was liquidated on the last day of the same year, while for HP2, the portfolio was liquidated on the last day of the following year, in this case 2006.

I want to highlight couple of observations

1. There are 3 one-year holding periods, when an investment in PP actually decreased the principal holding. One of those holding periods include the period of 2008 financial crash.
2. For two-year holding periods, the results are quite encouraging, with virtually  no loss in principal over any of the 2 year holding periods with an average rate-of-return of 4.93 %

The analysis above is certainly not a thorough investigation of the premise that PP can offer virtually risk-free investing opportunity.

However, it is not far-fetched to conclude that if the time horizon for the requirement for capital preservation for a major purchase such as a house is longer than a year, PP should be given a serious consideration as the  investment vehicle of choice to allow for participation in the market upside.

The second chart shows the annualized returns for PP and the Buffet-Portfolio. For the purpose of this analysis we consider, each portfolio as created in 2005 and held through today with annual rebalancing (resulting in a holding period of >12 years)

Two comments on the chart:

1. The big dip in annualized returns for the Buffet-Portfolio in 2008, and significant gains in annualized returns for Buffet-Portfolio in 2009 and 2013
2. PP managed to pull through the 2008 financial melt down quite well with annualized returns dipping to -1.6 % in 2008. On the other-hand, PP missed on the gains in the US-equity markets in 2013, primarily due to fall in gold prices.

The average annual returns for Buffet-Portfolio during the last 12 years was about 6.34 %, whereas the average returns for PP was about 5.25 %.

The volatality in returns for the two-portfolio put things in perspective.. Volatility (as measured by standard-deviation) in Buffet-Portfolio was 14. 7 % vs.  5.25 % for PP.

Does a volatality of 3X merit gains of 1 % on average? I think Not!

In summary, while PP may not be the panacea for virtually risk-free investments, PP certainly merits a second look as a sound strategy for retirement portfolio that has the potential to build sustainable wealth over a long-time horizon.

Notes

1. Additional resource for Permanent-Portfolio
   1. Book: Fail-Safe Investing: Lifelong Financial Security in 30 Minutes
   2. Book: The Permanent-Portfolio, Harry Browne’s Long-Term Investment Strategy
   3. Web-Article: Worlds best-investment strategy that nobody seems to like
   4. Web-Article: The Permanent Portfolio
2. ipython Notebook (to reproduce all the figures presented in this blog)