Review, Harry Browne and Markets on Close of Friday, September 2, 2011

This is an important post.  We will take stock of the market situation and then delve into philosophy, strategy and tactics of investing.  Along with the discussion of strategy we also will compare our strategy with that of Harry Browne.  Please note that I am not using the word “we” in these posts as the editorial we but as the collective we where I want to include the reader as part of the discussion.  Indeed I never want to stand apart from the readers.  We are in this together.

First, let us take stcok. We are equally invested in two portfolios, called the Default Portfolio and the Trading Portfolio.  We simplified both the portfolios as of August 8, 2011. Both portfolios at present are identical, holding 25% each in stocks (DIA), bonds (TLT), natural resources (GLD) and money market (SHY) as of August 8.

The market as measured by Dow Jones Industrial Average has advanced 3.90% from August 8 to September 2. Compared to that both of our portfolios have advanced 5.05%. We have again beaten the market and are doing quite well. But, don’t expect this to happen every time. We do not want to get spoiled or raise unrealistic expectations. However, we need to see what helped our achievement thus far.

I remarked in the post on August 8 that both gold and bonds had a huge run-up and a correction won’t be surprising. Instead, both have continued to run up even more, with gold going up 9.64% and bonds 6.59% over the same period.

We must keep in mind that our goal is not just to beat stock market. If stocks go down 10% and we go down 8%, we would have beaten the market. But still we would have lost 8%. We got to obtain a decent return on absolute basis in addition to the basis relative to stocks. We are doing it so far. Unlike many analysts and market pundits we do not hide our performance in a black box or anything like it. We are completely transparent in both portfolios, openly taking positions and keeping clear what the positions are at all times.

We are well-diversified and balanced in both portfolios and hold each portfolio as an organic unit.  So, please do not think as if every item of investment is a separate investment.  Notice but do not dwell on the performance of each item.  Do not think, for example, that stocks are volatile and are not doing well, etc.  The entire portfolio should be added up every time you look at it so that we think always and only in terms of bottom line performance.  That is because the portfolio is not just a sum but an organism with limbs.

A bit of review of our strategy is in order. You can go back to previous posts for detailed narrative on the strategy. But a brief review can be useful to new readers.  In the following discussion I will add considerable detail and reasoning about the philosophy of investing employed here.

I had heard of Harry Browne and his Permanent Portfolio. You can look both up in Google. But I had the occasion to look at Browne’s strategy in some depth recently. It is remarkably close to my strategy. There are some differences though. Browne brilliantly came to construct a permanent portfolio based on an ingenious application of Modern Portfolio Theory. He chose four asset classes on the basis of their inherent non-correlation. This makes his choices very effective as a package and does so on a relatively permanent basis. His package called Permanent Portfolio holds aggressive stocks, long term treasury bonds, gold and cash in equal proportions. My Default Portfolio comes close but it was not based on inherent non-correlations only.  It is based rather on a theoretical synoptic view of logically possible types of investing. I came to view investing as exhausting itself through two types: lending and owning. Lending is further divided into short term and long term. Short term is money market and long term is bonds. Alternatives in both are to be explored and one can invest in strongest of them on the basis of risk quality and change this periodically depending on rotating sub-sector strengths.  Owning is also divided but its division is not on time basis which makes sense with regard to lending but not with respect to owning. The division in owning is on the basis of whether one owns actual things or paper certificates of ownership such as shares in corporations. I called the former natural resources and the latter are of course the equities which represent legal ownership but with nothing physical to show. The natural resources of course are physical. I submit that these four asset types, namely, stocks, bonds, natural resources and money market isntruments, are logically exhaustive and therefore quite determinative. They are also distinct from each other.

When economy is growing, stocks do especially well. Economy at all times faces two dangers: inflation and recession. Natural resources protect against inflation because they increase in value if economy hits inflation. On the other hand bonds protect against recession because they do well when economy suffers recession. So our Default Portfolio is designed to do well in all three conditions of the economy. The 25% allocation in money market instruments defends the portfolio against volatility and serves as a general purpose hedge in a rare case when there is a total panic where everything goes down as what happened in 2008, for example. It also helps, as in the case of Browne’s Permanent Portfolio, in taking advantage of opportunities in other investment types.

The main tactic with Harry Browne is rebalancing the Permanent Portfolio when anything goes up beyond 35% or goes down below 15%. On the other hand it will be my tactic to rebalance twice a year at the time when annual seasonality changes course. This happens at the beginning of May and end of October.

Again, Browne recommended investing only in aggressive stocks, though later in his life he came to advocate market index, specially Standard and Poor’s 500 (SPY). My strategy would be to combine in equal proportions large cap and small cap stocks. And even this is variable, with an investor choosing strong or undervalued sectors, for example.

My allocation to natural resources is open to not just gold, as is the case with Browne. It is open to all metals, agricultural commodities, energy and real estate. But I agree with Browne that gold is the premier natural resource and I would not quarrel with a permanent filling of natural resources allocation with nothing but gold.  In fact Browne does not have a whole category called natural resources as I have.  He just has gold as an independent category.

In my recent exploration of Browne’s investment philosophy I found something great to learn from Browne and his followers. The latter have now compiled historical performance of the Permanent Portfolio. If you access it by Googling it, you can see its record from 1970 (the year when gold started trading freely) to date. The record is incredibly strong.  The performance is very steady, with remarkably little volatility and has yielded competitively with stocks about 9% with much less risk than stocks.

Why gold? What about those who have been burnt in gold during the eighties and nineties? They don’t want to touch it with a ten foot pole. Then there are academic economists who regard it as a barbarous relic and cannot stop calling it names. At the other extreme there are gold bugs who regard gold as real money and have no faith in paper currencies of any country. Gold is regarded as a hedge against inflation specially in developed nations of the West. This is the fear trade of gold. But now things have changed. We have powerful economies of emerging countries where people are getting richer and love to indulge in possessing gold which has become a status symbol. This is the love trade which has almost dislodged the fear trade from the prime position. Safe haven aspect of gold is well-known too. Gold has been outperforming even the Swiss Franc lately, a currency that is regarded as among the strongest. But then a reason why Swiss Franc is traditionally stronger than most currencies is that it is backed by gold more than other currencies!  Supply of gold is not about to increase dramatically.  Demand is increasing, along with prosperity in emerging nations.  September, for example is very strong in India for gold demand.  China and India account for about fifty per cent of gold consumption demand globally.  Add to it the fact that many central banks across the world have instituted buy programs in gold.

An interesting aspect of historical performance over the last forty years of Browne’s Permanent Portfolio is that it has never gone down more than 6.2% (in 1981) in any year. Compare that with stocks which have suffered losses up to 40 or 50 per cent in some years, with devastating effect. Incredibly, the Permanent Portfolio eked out a small gain even in 2008 when everything caved.

It is observed that when one or two assets go down substantially the third goes up dramatically making up more than the losses in both. Remember, because my four categories are logically exhaustive, money cannot go anywhere outside these four classes, and it has to go somewhere. More often two asset types will go up when one goes down. Of course money market investment remains steady never going down and going up only modestly, acting as a buffer and big protection. This is how even 25% gold position throughout the eighties and nineties did not matter because, guess what, both stocks and bonds went up dramatically, more than making up for losses in gold.

Browne was very insistent that there is no way to predict what markets will do and so one should always maintain positions in all the four categories.  I agree this has a grain of truth but it should not be held as a dogma either.  There certainly exist anomalies that can be taken advantage of in investing.  Also, individual investors can benefit from the lack of nimbleness of large institutional investors.

One of the most important aspects of our investment strategy is that we should never break the two portfolios into their constituents and think of our investment as if it is an investment in particular stocks, bonds or natural resources.  That would be disastrous.  Each portfolio is an organic unity and we should always think of its performance in terms of the bottom line which is the sum of all investment values every day and every week.  For example, if you have problems bringing yourself to invest in gold, think that you are not investing in gold as a separate item of investment.  Indeed that can be ruinous.  Gold here, or for that matter stocks, bonds and money market, support and complement each other and are held as one unit.  Each portfolio stands on its own.  You can start the Default Portfolio any time or any day but it should start as involving all its items in the proportions required.  Then it moves as one body and not one limb at a time.

Needless to say, there are no changes in our positions or allocations at this time.  I will come up with a post when we have a change.  Keep looking after mid-October.

I believe this brief review has not only recapitulated my investment philosophy detailed in previous posts but added to them in terms of discussing the total philosophy of investment strategy. Looking at Browne’s philosophy in this regard has helped me crystallize my ideas greatly. I hope you find all this helpful in your attempt to achieve financial freedom for yourself. Let me remind you as always to add and strengthen a significant spritual dimension to your economic efforts. Best wishes!



About Ramesh

Ramesh started investing in 1974. He has explored widely and deeply in the world of investing through avid reading and actual practicing all manners of strategies. Investing can be a fascinating journey by itself pointing to diverse challenges and points of learning about life and world. I would like to share my ideas and practices with all investors who seek not just monetary success but learning experience through the art and business of personal investing. Achieving financial health and freedom is an important goal in life. I would add, however, that having a spiritual dimension in life is equally, if not more, important.
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