With Michael Batnick, Director of Research at Ritholtz Wealth Management and writer of the blog Theirrelevantinvestor.com
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The definition of a permanent portfolio (in the U.S.) is one constructed of one-quarter U.S. stocks, one-quarter cash, one-quarter long-term government bonds, and one-quarter gold—simple and easy to understand.
Michael Batnick, Director of Research at Ritholtz Wealth Management and writer of the blog Theirrelevantinvestor.com
explains to our listeners the benefits and drawbacks of the permanent portfolio and why it’s not for everyone.
With an equal distribution of asset allocations, a permanent portfolio is resistant to volatility; in fact, Michael estimates it may be about half—or even less—as vulnerable to market volatility as a standard 60 stocks/40 bonds portfolio. That’s a positive feature. When a bear market hits and stocks are dropping like acorns from an oak in a windstorm, you can sit back and relax.
Not for the faint of heart investor.
But what happens to your serenity in a bull market when stocks are rising and your brother-in-law with the 60/40 portfolio is dancing in the street and ordering a private jet with his earnings? That’s not so much fun. The challenge for the permanent portfolio investor is having the ability to sit back through these upsides in the market and watch everyone around you making so much money.
Since we all know that what goes up must eventually come down, Michael reminds us that, although bull markets are comparatively long, a bear market always follows and the gnashing of the teeth through those downturns strikes a heavy emotional toll. As Michael tells it, “The challenge with the 60/40 portfolio is, of course, that the bear markets are quick and they’re vicious. Eighteen months doesn’t feel that quick, but the challenge of the permanent portfolio is that the bull markets are so long.” You have to have the mentality to hang in there.
The permanent portfolio versus the classic 60/40
Going back to 1976 when Barclay’s Aggregate Bond Index began, the classic 60/40 portfolio did just a bit over 10% a year and the permanent portfolio did a little less at 8.4% a year, which doesn’t seem like so much until you consider the difference that 1 ¾% can make. One dollar would have had a total return of 5000% with the 60/40 and only 2600% with the permanent. Less wealth created, for sure, but the permanent portfolio gives you the ability to stay invested for 30 or 40 years, but you must give yourself reasonable expectations.
Holding a permanent portfolio in today’s environment might require the stoicism of a monk— stocks are rising, cash is at zero, and bonds and gold are dropping. However, when the downside occurs, it’s just the opposite for the permanent portfolio investor who can sit back and snooze while the economy trembles. But, Michael adds “…expansions are much longer lasting than contractions. They (permanent portfolio investors) sit around waiting for the last laugh, but they could be waiting for a decade or more.”
It’s a choice not every investor is willing to make.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: From time to time, people come up to me and ask me if I’ve ever heard of the strategy called the permanent portfolio. Of course, I have because it’s one of those ideas that is so simple, and it’s something that practically everyone can understand, and it looks like it might just work. Michael Batnick, Director of Research at Ritholtz Wealth Management, has taken a much closer look at it, so I asked him to join me today. Hey, Michael, welcome back to the show.
Michael Batnick: Thanks for having me back, Steve.
Steve Pomeranz: This thing called the permanent portfolio, what is the makeup of it?
Michael Batnick: So, the actual construction of the portfolio is, from the perspective of a US investor, it’s US stocks, US large kept stocks, cash or one month T-bills, which is essentially the same thing as cash, especially right now, long-term government bonds, and, everyone’s favorite, gold.
Steve Pomeranz: Gold.
Michael Batnick: That’s split up equally 25% a piece.
Steve Pomeranz: Okay. One quarter US stocks, one-quarter cash, one- quarter long-term government bonds, and one-quarter gold. These seem to be asset categories that ying and yang differently. They seem to be relatively low correlated, in some cases uncorrelated. Let’s look at our situation currently today. We have the stock market rising, so one-quarter of the portfolio we know would be rising here, US stocks.
Michael Batnick: Yep.
Steve Pomeranz: We have cash, which, of course, is pretty much zero and has been for a long time. Now, government bond prices have been dropping, so that would be a negative and gold would be dropping, so that would be a negative. In today’s environment, it seems like if you had an analogy of a four-cylinder car, only one cylinder seems to be working and the others actually seem to either to be not working or actually moving in reverse. What do you think about that?
Michael Batnick: Yep. I would phrase it a little bit differently. Not working is what most people would say, but that’s not really the case. What’s happening is that they’re going in different directions. It is working; it’s just that three-quarters of the portfolio’s going in a different direction than you would like to see them. One of the allures of this portfolio is, to your point, that each quarter or each piece of this portfolio really responds differently to different environments. They don’t always respond differently to the same environments or the same to different environments, but they do ying and yang and zig and zag and that’s the whole point of any portfolio, but particularly this one.
Steve Pomeranz: Yeah. This one seems to be the case where it would be pretty dramatic. Let’s compare it to the classic 60/40 allocation that would be 60% stocks, 40% bonds, and we want to compare that to the permanent portfolio. What generic manufacturers of hydrocodone have been the rate of returns for each strategy?
Michael Batnick: All right. Going back to 1976—I’m not just cherry- picking, that’s when the Barclay’s Aggregate Bond Index started, so that’s why I anchor to that date—the 60/40 portfolio did around just a smidge over 10% a year and then the permanent portfolio did a little bit less, 8.4% a year but, of course, a little bit over a long period of time makes a big, big, big difference. Just to show you how much one and three-quarters of a percentage point can make, one dollar would have had a total return of 5000% for the 60/40 portfolio and only 2600%, so just half basically, for the permanent portfolio.
Steve Pomeranz: There was a chart in your article that said a dollar invested in 1976 for the S&P 500, which is 100% stocks, obviously, is worth about $78. A dollar in a 60/40 portfolio is worth $51 and in the permanent portfolio it’s worth $27. Significantly less wealth created, but you get something in return when you’re investing in this kind of strategy. What is that?
Michael Batnick: What you’re getting is, theoretically, actually the ability to stay invested for 30, 40 years, which is perhaps unrealistic with any strategy, but that’s the whole idea of the permanent portfolio. You have to give yourself reasonable expectations. Obviously, the allure of the permanent portfolio is the draw-downs are very, very shallow. They tended to not be much more than 15%, if I recall, versus even the 60/40 portfolio gets demolished. The tradeoff of missing the downside is you miss much of the upside. Let’s be honest for a second, staying 100% invested in stocks is basically an option for nobody and even people that think that they can hang with the 60/40 portfolio might be fooling themselves. The permanent portfolio, what you give up on the upside, you gain from a psychological perspective in that you’re actually going to be able to sleep when the world is ostensibly ending.
Steve Pomeranz: Okay. Fair enough. Let’s repeat that in another way. First of all, all these returns that we gave assume no transaction cost and, when you’re investing in gold, before the exchange traded fund GLD was created, you had to go out and buy the real thing and hold it at a significant cost and buy it at a significant markup. I really want to put that caveat out there. We’re really talking more conceptual than anything else, but it gives us a good roadmap for where we’re going.
Michael, what you’re saying is that one of the factors that keeps people invested is the degree of volatility in their portfolio. When the market goes down by 40%, it’s very, very hard for, let’s say, a 100% stock investor to hold tight. You’ve accumulated your money year after year after year after year; let’s say you got it to a million bucks. The stock market within a six- month period of time goes down, takes your money down to 600,000. Nobody can foretell the future; that’s some scary stuff. A lot of people get really freaked out by that and they do the wrong thing.
The volatility on the permanent portfolio is lower—is that what you’re saying—than a standard 60/40 or the S&P 500?
Michael Batnick: Yeah. Two important things. The volatility of the permanent portfolio is way, way, way lower. I think it’s about half, but I’m not positive. It’s way lower. However, you have to think about the volatility relative to the volatility and what I mean by that is … The permanent portfolio is a very, very different portfolio and it requires a very specific type of mentality.
Steve Pomeranz: Yes.
Michael Batnick: The challenge with the 60/40 portfolio is, of course, that the bear markets are quick and they’re vicious. Quick, say 18 months doesn’t feel that quick, but the challenge of the permanent portfolio is that the bull markets are so long. How long can you watch your neighbor, your idiot neighbor who thinks everything’s hunky dory and doesn’t believe in [inaudible 00:07:25]. How long can you watch that person accumulate wealth and rub it in your face before you say, “You know what? Maybe I’m overdoing it with this permanent portfolio.”
I can totally get behind the actual construction of the permanent portfolio. It makes a lot of sense. I just doubt somebody’s ability to stick with it through thick and thin. By the way, I also sort of equally doubt the ability of someone to stay the course in any portfolio. I was just trying to show a different way of doing it, particularly, in this environment where people are afraid of low returns going forward. Having a portfolio that you can stick with, it sounds cliched-
Steve Pomeranz: That has value. There’s something to that. Wait a minute. I want to get back to something you just said.
There’s this thing about human nature. The guy next door, he just bought a beautiful new car, he’s got a big house, and he’s been in the market and his wife says to him, “You know, you’re smarter than him. How come you’re not doing as well as him in the market?”
Michael Batnick: Right. Exactly.
Steve Pomeranz: This is the kind of psychology that gets us in trouble. He’s trading internet stocks, internet stocks are booming, you’re being very conservative. You’re buying Johnson & Johnson and nobody likes Johnson & Johnson anymore and GE is boring and yet he’s making all this money. You feel like you’re smarter than him.
Here’s the thing. It’s one thing you get a little satisfaction if internet stocks start to go down and your portfolio starts to look like the smart portfolio, but with the permanent portfolio, you won’t participate in those bull markets for a really, really long period of time, or your participation will be minimal. You’ve got to sit there and watch your idiot neighbor make all this money and that’s really hard to do.
Michael Batnick: That’s exactly right. The challenge of the classic 60/40 investor is, “How do I survive on the downside?” Now the challenge of the permanent portfolio is the exact opposite. It’s, “How do I survive on the upside?” We know that the expansions are much longer lasting than the contractions. They’re waiting for the last laugh, but they could be waiting for a decade or more.
Steve Pomeranz: A good discussion about the permanent portfolio. One- quarter US stocks, one-quarter cash, one-quarter long-term bonds—I feel like I’m ordering from a Chinese menu—and one-quarter gold. Michael Batnick, Director of Research at Ritholtz Wealth Management. Thanks, Michael.
Michael Batnick: My pleasure.