Financial planning: is a permanent portfolio strategy a safer bet?
The permanent portfolio strategy aims to provide both growth and low volatility to investors, performing well in times of economic growth as well as in times of recession.
Given the current market volatility, investors are uncertain about the financial markets and the investment strategy they should adopt now. However, instead of panicking, it is important that investors take this opportunity to re-evaluate their current long-term investment strategy to find ways to improve their portfolio performance. It is a challenge not only for new investors but also for experienced investors to decide how to construct an investment portfolio that will optimize growth while minimizing risk.
When building a long-term portfolio, diversification between different asset classes is a key factor. But what is the best way to diversify? Let’s find out the answer for the same through a permanent portfolio investment strategy.
Mechanics of the permanent portfolio strategy
The concept of a permanent portfolio was introduced by open market investment analyst Harry Browne. The objective of the permanent portfolio is to ensure a good return during periods of economic growth and recession. It aims to provide both growth and low volatility and empirical evidence indicates that this strategy has been successful.
Some asset classes will do well, others will do poorly. Instead of trying to predict which asset classes will outperform, it contains four basic negatively correlated asset types, which counterbalance each other. Overall, the portfolio grows as well as, and sometimes even better than, the stock market as a whole, without large swings in volatility that are difficult to manage.
A zero forecast is required
No one can predict what will happen in the future. Promises of predicting the future in investing are rampant and likely lead to big losses and bad investment decisions. As part of the permanent portfolio asset allocation strategy, no forecast is required; rather, it recognizes the fact that the situation in the financial markets will always change.
Largely eliminates waste
Investors around the world hate to lose and they even hate the potential or the perception of a loss. This phenomenon is known as “loss aversion” and is the reason why investors end up buying high and selling low instead of the other way around.
Under this strategy, investors create a portfolio of four basic negatively correlated asset types, such as stocks, bonds, gold and cash. People enthusiastically buy these four major asset classes when things are going well, or retreat to them when things get scary. When business is good, everyone is excited about stocks. When inflation, deflation or recession looms, investors flee stocks to bonds, gold and Treasuries. By holding all four asset classes, returns are stable regardless of the vagaries of the market. Gold and bonds are seen as safe havens during times of recession and inflation, while the stock market provides growth during economic booms. Cash (treasury bills) is stable and provides a source of funds for rebalancing and downturns in the economy.
To conclude, this strategy supports all situations like prosperity, inflation, deflation and recession. Rather than trying to predict the market and move funds accordingly, this is a simple strategy for long-term investing. Managing a permanent portfolio is quite simple once it is set up. It is advisable to rebalance the portfolio at least once a year to ensure that individual allocations remain at the pre-allocated levels of 25%.
The author is Professor of Finance and Accounting, IIM Tiruchirappalli.