My latest note for Epsilon Theory is a golf lesson we can apply to our portfolios.
The most grievous portfolio construction issues I see inevitably seem to center on basic issues of strategy and commitment. Particularly around whether a portfolio should be built to seek alpha or simply harvest beta(s).
You don’t have to shape your shots every which way and put crazy backspin on the ball to break 90 in golf. Likewise, not every portfolio needs to, or even should, strive for alpha generation.
There are few things more destructive (or ridiculous) you can witness on a golf course than a 20 handicap trying to play like a 5 handicap. And it’s the same with portfolios. For example, burying a highly concentrated, high conviction manager in a 25 manager portfolio at a 4% weight. Or adding a low volatility, market neutral strategy to an otherwise high volatility equity allocation at a 2% weight.
This is a quick post to share an update of this running model of expected S&P 500 returns using Federal Reserve data. As of March 31, the model predicted an 8.12% annualized return over the next 10 years. This has likely come down a bit further since then as the market rallied. As of today, we might be somewhere in the 6-7% range.
Given there’s so much wailing and gnashing of teeth over macro risks these days it’s worth emphasizing a couple points.
First, this model is useless as a short-term timing signal. Don’t try and use it that way. If you’re looking for short-term signals you need to be looking at trend following systems and such.
Where I think there’s some utility here is as a data point you can use to help set longer-term return expectations and guide strategic asset allocation decisions (particularly when used alongside other indicators like credit spreads). When the aggregate equity allocation is close to 40% or above, it signals lower expected returns and argues for taking down US equity risk. Between 30% and 40% it signals “meh.” Probably not worth making any adjustments in this range. At least not on the basis of this model. At or below 30%, however, the model argues for adding equity risk.
Also, what I like about this model is that unlike indicators such as the CAPE or market cap/GDP what you are really measuring here is the aggregate investor preference for fixed income versus equities. When investors are very comfortable owning equities they bid up prices and expected returns fall. When investors are not comfortable owning equities they sell, prices fall and expected returns rise.
That’s the ball game.
No macro forecasting is required.
You don’t have to make any judgment calls on valuations, either.
What I would love to do eventually is run this for countries outside the US. What I suspect is that the ex-US models would show similar efficacy but with different “preferred” bands of equity exposure based on the culture of equity ownership in each country and whether or not there’s a significant impact from “hot money” flows from foreign investors.
I’m not aware of a straightforward way to find the data needed to do this. But if anyone has suggestions, please drop me a line.
May afforded an interesting opportunity to test the leveraged permanent portfolio strategy out of sample. (For previous posts on the permanent portfolio, see here and here) Below is data showing the results for two different leveraged permanent portfolio implementations, compared to the Vanguard Balanced Index Fund (an investable proxy for a 60/40 portfolio) and SPY. You can do a deeper dive into the data here.
NTSX’s laddered Treasuries provided better downside protection than the StocksPLUS bond portfolio here. But the gold exposure was also a major help, with GLD returning +1.76%. Obviously this is just a single month of performance, but the results are consistent with what you might expect based on backtests of the strategy.
Notice that the performance pattern is similar during the 4Q18 drawdown. In each case, the drawdowns are less severe than even those experienced in the 60/40 portfolio due to the diversifying impact of the gold. Because again, where the leveraged permanent portfolio shines is downside protection. You aren’t capturing all the upside of a 100% SPY allocation, but you’re capturing only a fraction of the downside.
Since December 2004, the PSPAX/GLD portfolio has captured 60% of the upside of SPY but only 43% of the downside. The asymmetry means PSPAX/GLD slightly outperforms SPY over this time period, but with less volatility. More importantly, the max drawdown is only a little more than half as bad.
Still, in my view the biggest problem the leveraged permanent portfolio presents for investors is precisely that its outperformance comes in down markets. This isn’t a sexy way to make money. It’s not the kind of thing that impresses people at cocktail parties. The behavioral challenges this presents should not be underestimated.
But personally, I’ll take a 10.62% safe withdrawal rate over cocktail chatter any day.
We’re all familiar with the old saw: “correlation is not causation.” Correlation is merely a statistical measure of the strength of the linear relationship between two variables. Correlations can change over time. The fancy stats word for this instability is “nonstationarity.”
Anyway, what I want to suggest in this post is that correlations can often be interpreted as markers of meaning.
For example, stocks and Treasury bonds have been negatively correlated since the financial crisis. The reason is that the meaning of Treasuries to investors, broadly speaking, is “safe haven asset.” A Treasury allocation is an allocation that will perform well in a deflationary environment. And deflation, broadly construed, has topped the list of investor fears for many years now.
A big mistake many investors (particularly younger investors) may make is assuming Treasuries will always be negatively correlated with stocks. This has not always been true historically and will not necessarily be the case in the future. Why? In a highly inflationary environment, both stocks and Treasuries will perform poorly. The two assets classes will become positively correlated.
Another example of this is gold. Traditionally, gold has been viewed as an inflation hedge and has been positively correlated with inflation expectations. These days, however, gold is liable to trade up on deflation fears as well as inflation fears. Why the change in correlation? The meaning of gold has changed. Gold has shifted from a pure inflation hedge to an insurance policy against economic chaos more generally. Gold is now a hedge against policy mistakes by our economic elites (our Ever Wise and Benevolent Central Bankers in particular).
What I’m driving at here is that if you want to better understand the nonstationarity of correlations, you ought to spend some time thinking about narrative.
A stable correlation is a correlation where objective meaning dominates. Objective statements can be proven true or false in a straightforward way. Unstable correlations are correlations where subjective meaning dominates. Subjective statements cannot be proven true or false in a straightforward way. Subjective statements are reflexive.
George Soros described it this way:
Consider the statement, “it is raining.” That statement is true or false depending on whether it is, in fact, raining. Now consider the statement, “This is a revolutionary moment.” That statement is reflexive, and its truth value depends on the impact it makes.
There’s not much subjective judgement required to evaluate a Treasury bond as an investment. It’s a mostly objective process that more or less boils down to your views on the future path of inflation and interest rates.
Now, your views on inflation and interest rates may make Treasury bonds seem relatively more or less attractive to you at any given point in time. But there’s never any real question in anyone’s mind as to how Treasury bonds will perform in a deflationary environment versus an inflationary environment. This is what I’m driving at when I say the meaning of a Treasury bond for your portfolio is going to remain pretty stable over time. A Treasury bond is protection from deflation.
Credit is a bit more subjective than Treasury bonds because now you’ve got defaults and recoveries in the mix. And equity valuation is far more subjective than credit valuation because the timing and amounts of the cash flows associated with equities are highly variable.
The value of gold is an order of magnitude more subjective than even equities because there aren’t any cash flows associated with gold. Gold is a purely speculative asset. Gold has value because, for whatever reason, human beings have arrived at the collective consensus that it’s a store of value over tens of thousands of years.
At the extreme end of this spectrum you have something like Bitcoin. Bitcoin, of course, has no cash flows. On top of that, there’s no broad consensus regarding what Bitcoin means. Sometimes it’s a currency. Sometimes it’s a speculative risk asset. Sometimes it’s a store of value or even a safe haven asset.
You ought to be extremely skeptical of any MPT-style analysis of Bitcoin’s role in a portfolio at this point. You simply can’t know if, when or how its correlation with other portfolio assets is going to stabilize over time. Just because Bitcoin is uncorrelated today doesn’t mean it will continue to be uncorrelated in the future.
Another practical application of all this relates to factor investing.
Patterns of correlations are the building blocks for factor-based investment strategies (they are literally what the math going on under the hood is measuring). It’s well-known that factor strategies go through extended periods of outperformance and underperformance that are difficult, if not impossible, to time. Factor performance comes and goes in irregular regimes. Regimes are driven by a mixture of objective and subjective factors that influence one another in feedback loops.
If you’re trying to figure out when the relative underperformance of value stocks will end, you need to be thinking about what in the zeitgeist and market regime needs to change so that investors will want to buy stocks with “value” characteristics (how you choose to define “value” is important here). For example, in late 2016 the election of Donald Trump triggered a massive rally in cyclical industrial and financial services stocks. If you’re a long-suffering, old-school value investor who owns a lot of these stocks, what you want at a high level is higher growth, (modestly) higher inflation and (modestly) higher long-term interest rates.
If you’re a growth-oriented investor, such as a VC, who owns unprofitable, high-growth businesses that will not generate free cash flows for many years, what you want is a regime with solid growth but even more importantly with low inflation. More specifically, low interest rates. The value of your equity ownership is extremely sensitive to the cost of capital because your investments are very long duration. Much like a zero coupon bond, their cash flows lie far out in the future.
So anyway, when you’re considering factors such as value and growth what you want to be thinking about when evaluating their potential persistence over time are the drivers of the underlying patterns of correlation. And if you go through this exercise enough, I think you’ll find you keep coming back to investor preferences for different cash flow profiles.
Investment returns are always and everywhere a behavioral phenomenon.
Because, in the words of Marty Whitman, we’re pretty much always looking for a “cash bailout” when it comes to our investments. And our ability to exit an investment almost always ends up depending on a sale to another party. Marty wrote a wonderful explanation of this in an old investor letter (I’ll end on this note because I think it’s a fitting conclusion for this post):
From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.
A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.
There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:
Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.
Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.
Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.
I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market
Financialization is all about using financial engineering techniques, either securitization or borrowing, to transfer risk. More specifically, financialization is about the systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff structures.
In business, and especially in finance, we see this playing out everywhere.
Debt-financed share buybacks? HIWTYL.
Highly-leveraged, dropdown yieldcos? HIWTYL.
Options strategies that systematically sell tail risk for (shudder) “income”? HIWTYL.
Management fee plus carry fee structures? HIWTYL.
Literally every legal doc ever written for a fund? HIWTYL.
There are two ways to effectively handle a counterparty that has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game only if you have some ability to retaliate if your counterpaty screws you. Legal action doesn’t count. The docs and disclosures are written to be HIWTYL, remember?
(aside: corporate borrowing can be viewed as management selling put options on a company’s assets. I’ll leave it to you to consider what that might imply about government borrowing)
You need to be in a position to hurt your counterparty for real.
You need to be in a position to hurt your counterparty economically.
A friend (who is not in finance) recently asked me about the relationship between the sell-side and the buy-side. His question was basically this: is the purpose of investment banking just to rip fee revenue out of people by whatever means necessary even if it involves deliberately misleading them to screw them over?
My answer is that the sell-side’s purpose is simply to facilitate transactions. For investment bankers, that means raising capital or advising on M&A deals or whatever. For sell-side research groups it means driving buy and sell transactions.
We poke fun at the sell-side around here, but what we’re poking fun at is just the sell-side’s Buddha nature. The zen master Shunryu Suzuki described Buddha nature thusly:
“If something exists, it has its own true nature, its Buddha nature. In the Parinirvana Sutra Buddha says, “Everything has a Buddha nature,” but Dogen reads it in this way: “Everything is Buddha nature.” There is a difference. If you say, “Everything has Buddha nature,” it means Buddha nature is in each existence, so Buddha nature and each existence are different. But when you say, “Everything is Buddha nature,” it means everything is Buddha nature itself.”
A scorpion asks a frog to carry it across a river. The frog hesitates, afraid of being stung by the scorpion, but the scorpion argues that if it did that, they would both drown. The frog considers this argument sensible and agrees to transport the scorpion. The scorpion climbs onto the frog’s back and the frog begins to swim, but midway across the river, the scorpion stings the frog, dooming them both. The dying frog asks the scorpion why it stung the frog, to which the scorpion replies “I couldn’t help it. It’s in my nature.”
I sold my Gazprom ADRs yesterday. The shares popped nearly 22% after the company proposed a 60% increase in its 2018 dividend. If you are unfamiliar with Gazprom, it is Russia’s state-owned natural gas behemoth. It is also probably one of the cheapest non-distressed stocks in the world on an absolute basis.
My truest investing self is a Ben Graham-style bottom-feeder who is happiest scooping up feared and loathed investments at significant discounts to book value. This is stuff that’s gotten so cheap all you need is for things not to deteriorate too significantly and you will make some money. Meanwhile, if things break even a little bit your way you stand to make a lot of money. It is the kind of stuff that sometimes actually makes people angry when you tell them you own it.
There are not many places in the world today where you can find non-distressed businesses trading at massive discounts to book value or on 5x earnings or whatever.
But you can find them in Russia.
To me, it is beyond question that Gazprom trades at a massive discount to the value of its net assets. You don’t exactly have to be an accounting wonk to understand that. Gazprom controls almost 20% of global natural gas reserves and supplies nearly 40% of Europe’s natural gas. It trades at 0.3x book value.
The problem you have is that the market has to believe there is a realistic path to unlocking that value in order for the stock to trade up.
Read that again. Slowly.
It is critical to understand Gazprom doesn’t have to actually unlock any value for the stock to work. The market just has to believe it will. In fact, if the market begins toassign even a modest probability to management unlocking value, the stock will start to work.
This is still not straightforward for a company like Gazprom, where it’s pretty obvious the company is being looted and the Russian state is at a minimum complicit in the looting, if not itself the architect of the looting. There was a Sberbank equity analyst, Alexander Fak, who made a compelling case Gazprom is being looted primarily via its capex. (A bit too compelling a case, apparently, as Mr. Fak was fired soon after issuing his report)
Which brings me to the reason I am content to sell my Gazprom ADRs now, despite the fact they may trade up further in the short-term. Because of all its capex, Gazprom is free cash flow negative. By my calculation, management is proposing paying out something like RUB 380 billion of dividends for 2018. Fine and dandy on a net income of RUB 1,456 billion but not so much on free cash flow of RUB -22 billion.
My take on this is that the Russian state is engaged in some first-class financial engineering: loot the company via capex and plug any holes with borrowing. Dividend Recap: SOE Edition!
As an investor, it’s never a good idea to rely on fat dividends that aren’t backed by robust free cash flow to support an investment case. Us bottom-feeders tend to learn this the hard way early on in our investing, by averaging down value traps.
Could Gazprom play this financial shell game forever? Sure. The company is a quasi-sovereign entity. But there is a price above which I am less and less thrilled about entrusting the fate of my investment to the amity and goodwill of the Russian state and for me that threshold was about $5.65 per ADR.
Maybe some day Gazprom’s capex will come down and the financials will make a bit more sense. If so, I may happily own it again. But for now this is one of those cases where “money talks and bullshit walks.”
My Larger Point
For those of you who are also Ben Graham-style bottom feeders, I cannot emphasize the importance of catalysts for these types of investments enough. In this day and age, stuff that gets this cheap tends to be cheap for a reason. To the extent you’re not looking at a value trap you are almost certainly looking at something where there is a major impediment to value realization.
One of the things I spend more and more time thinking about on the up-front now is how those impediments might be cleared. I must admit I didn’t spend enough time thinking about this with Gazprom when I initially invested.
Shareholder activism is one obvious solution. If an activist is involved, congratulations! You’ve got a catalyst. Whether the activist’s agenda is aligned with your own, and whether the activist will succeed in implementing that agenda, are different things all together. But you’re not dead in the water.
Another potential solution is a management team that’s good at capital allocation. Management teams that are thoughtful about capital allocation will take action to close obvious value gaps. In Gazprom’s case, what a thoughtful management team not involved in looting the company would be doing would be cutting back on capex to whatever extent possible and buying back stock hand over fist.
Be wary of situations where a stock is cheap but management is entrenched and is engaged in looting the business. Gazprom is an example of this in Russia. Biglari Holdings is a great example in the US.
Then again, to paraphrase Seth Klarman, everything’s a sell at one price and a buy at another. So maybe sometimes take your chances.
Last week’s permanent portfolio post generated some great questions and feedback, so I wanted to do a follow-up post addressing some of the most common issues raised.
That’s a big allocation to gold. What about using REITs instead of gold?
Admittedly, gold has a lot of issues as an asset. The biggest issue with gold is that it’s a negative carry asset. Not only is there no yield on gold, but there are also costs associated with storing it (fun fact: your primary residence is also a negative carry asset unless you rent out a room or two).
In theory, it would make a lot of sense to allocate to REITs in place of gold. In an inflationary environment, the real value of the properties would increase while the real value of any debt on them would decrease.
I was able to pull US Equity REIT return data from NAREIT back to 1972 and run a new backtest looking at two different approaches to a REIT allocation. (h/t to @IrvingFisher15 for pointing me to this data on Twitter) The first portfolio swaps half the gold allocation for REITs. The second portfolio swaps half the US equity exposure for a dedicated allocation to REITS. I compared both to a 100% US Equity allocation.
By swapping some gold for REITs you improve the portfolio’s return and volatility profile but at the cost of greater drawdowns and greater correlation with the US equity market.
To me, a decision on this comes down to each investor’s preferred risk exposures.
In a barbell approach to portfolio construction such as the one that I favor, I would opt not to replace gold with REITs, because the whole point is to mitigate drawdowns in the “core” sleeve of the portfolio. The opportunistic sleeve of the portfolio will necessarily contain a significant amount of equity risk. This may include real estate exposure.
Someone who is implementing the permanent portfolio as a standalone portfolio, however, would likely prefer the return profile where REITs replace some of the gold.
In the basic permanent portfolio, there’s not enough equity exposure.
Usually I find when people say “there’s not enough equity exposure” what they’re really saying is “the CAGR is too low relative to my return hurdle.” We’ve been conditioned to believe that when CAGRs are too low the only solution is to take more equity risk. But that’s not necessarily true.
This is where the leveraged permanent portfolio concept comes into play. To illustrate what this might look like for a DIY investor, I backtested a simple implementation of a leveraged permanent portfolio.
Portfolio #1 is a 50/50 allocation to PIMCO StocksPLUS and GLD. The PIMCO fund uses a bond portfolio to collateralize a 100% net long exposure to S&P 500 futures for 200% notional exposure. So, at the portfolio level, this portfolio is 50% bonds, 50% stocks and 50% gold for 150% notional exposure.
Portfolio #2 is a 100% allocation to SPY as an investable proxy for the S&P 500.
Vanguard Balanced Index is included as an investable proxy benchmark for a traditional 60/40 allocation.
Below are the results.
While this is a relatively short time period, I find the results quite compelling. The leverage allows you to increase portfolio returns without adding equity exposure. While the addition of leverage does increase portfolio drawdowns, you’ve gotten a slightly better return than a 100% SPY portfolio with drawdown characteristics similar to a 60/40 portfolio. And again, in the bargain you’re much better protected from an inflationary regime than you would be using either of the alternatives.
One of the most significant shifts in my thinking around asset allocation over time has been to embrace the use of a modest amount of leverage to build more diversified portfolios that are still capable of meeting investors’ return hurdles. I guess I am slowly but surely transforming into a risk parity guy. Of course, the REIT-for-gold switch discussed earlier in this post is also a form of levering a portfolio (REITs are leveraged assets).
Anyway, I’d be remiss to move on without commenting on what I believe is the biggest issue with implementing a permanent portfolio, either levered or unlevered, for an actual client. Particularly a retail advisory client. The issue is that the portfolio massively underperforms equity markets in strong bull markets. So it’s absolutely critical a permanent portfolio investor remain focused on absolute returns in these types of environments. Otherwise, envy will lead to FOMO and FOMO to bailing out of the strategy at EXACTLY the wrong time.
The permanent portfolio truly shines when equity markets are getting hammered, either due to inflation or deflation. It’s not a sexy way to generate returns. The behavioral challenges this presents for investors should not be underestimated.
And for what it’s worth, I don’t think there’s a “solution” for this. Either people are willing to accept the potential opportunity costs of the strategy and cultivate the discipline necessary to stick with it through thick and thin, or they’re not.
What about replacing the gold allocation with trend following or Bitcoin or other uncorrelated alternatives?
By all means! Knock yourselves out. Gold was merely the easiest uncorrelated alternative for me to backtest, and also (probably) the easiest for the DIY investor or retail financial advisor to actually implement at this time. Furthermore, it doesn’t require the investor to bet on a specific investment manager to implement.
But I think it’s perfectly valid to replace the gold allocation with other uncorrelated alternatives. A word of caution, however: in my view the use of other alternatives should be biased toward strategies that perform well specifically in inflationary market regimes. That’s the whole point of owning gold here.
Why no credit exposure?
As alluded to above, this exercise was based on the K.I.S.S principle (Keep It Simple, Stupid). I have mixed feelings about how best to integrate credit in a permanent portfolio. Investment grade credit probably has a home in the bond bucket, though it will introduce a bit more equity-like sensitivity to deflationary conditions.
The lower down the credit quality spectrum you go, or the more you get into hybrid securities like preferred stocks, the more you take on equity-like risk. So to the extent assets such as high-yield debt and bank loans and preferred stocks have a place in the permanent portfolio, it’s actually in the equity bucket.
The permanent portfolio is all about balancing risk exposures in light of their potential patterns of correlation across different macroeconomic and financial market regimes. Asset classes get sorted into buckets based on their historical sensitivities to those regimes and (hopefully) how robust those relationships may prove to be in the future.
This is precisely the same intuition that underlies most flavors of risk parity, including Bridgewater’s famous All-Weather portfolio. The advantage Bridgewater and other large investors have here is that they have access to the full toolbox of financial instruments for portfolio construction. Smaller investors have to hack something together based on the investments they can access.
If you’ve read this blog for any length of time it’ll come as no surprise to hear that I’m rather disillusioned with the prevailing wisdom around asset allocation. It goes something like this:
Adjust a 60/40 split based on your age and risk tolerance and close your eyes for 40 years or so and the world will probably be a better place when you finally open them again. Here are some charts showing “long term” equity returns to make you feel better about enduring 50% drawdowns.
Here are my key issues with the prevailing wisdom:
Prevailing wisdom is biased heavily toward equities based on historical experience. This is the market Skinner box in action. There are no physical laws requiring future equity returns to look like past equity returns over any particular length of time.
Equity risk drives outcomes within most portfolios, despite these portfolios appearing more diverse when visualized in a pie chart.
The notion of “the long term” is at best squishy. “Long term,” we’re all dead. No one’s investment time horizon is infinite. We ignore sequence risk at our peril.
Prevailing wisdom is robust to neither inflationary nor deflationary busts. Which are really the conditions that ought to keep us up at night. Particularly inflationary busts. Because other than a few cranks no one is prepared to invest in a highly inflationary environment these days. (What? You think the inflation of the early 1970s or 1980s can’t happen again? LOL. Just Google MMT )
So this is going to be a post about the permanent portfolio, which is where I’ve landed as an alternative to the prevailing wisdom. This post should absolutely not be taken as investment advice. There are opportunity costs involved here and they may be significant. Particularly if your inclination would otherwise be to allocate 60/40 to US stocks/bonds and US equity continues its run of strong returns for an extended period of time. See my disclaimer for more on why making investment decisions based on random blog posts is an incredibly stupid thing to do.
Fundamental Assumptions & Principles
There are some key assumptions underlying my views on all this. I want to lay them out explicitly up front, because many of these can be debated endlessly. I’m not trying to argue all of this is capital-t Truth. This is simply the framework I’m operating within.* So for example, if you’re a guy or gal who wants to own five stocks forever, I’m not trying to convince you to do it differently. And you’re probably not going to agree with any of this. That’s fine.
We should build portfolios as regret minimizers and not utility maximizers. Note that regret minimization is subjective. We can regret both realized losses AND foregone gains. The exact “regret function” will vary with each individual. The first sentence of this bullet is in bold because it’s the foundation for everything else. I’d hypothesize that human beings in general tend more toward regret minimization than utility maximization. But I can’t prove that.
The starting point for any portfolio should be wealth allocation. A wealth allocation consists of at most three buckets. It is possible and sometimes even desirable to have fewer. Wealth allocation is consistent with regret minimization.
Equity ownership is absolutely essential for preserving and growing purchasing power over long time periods. However, equities can go through substantial and lengthy drawdowns. Major drawdowns are problematic in a number of ways:
They create sequence of returns risk for the portfolio (e.g. massive drawdown immediately prior to retirement)
They may encourage poor investor behavior (buying high and selling low)
The portfolio will have the least liquidity and buying power when expected returns are highest (e.g. at the trough of a major drawdown), preventing opportunistic purchases of assets subject to forced selling, etc.
Reliably forecasting economic cycles for the purpose of tactical asset allocation is impossible.
Traditional methods of hedging tail risk are frequently expensive and can be a significant drag on returns if utilized in meaningful size. They can also be extremely challenging, if not impossible, for individual investors to implement.
Ideally what we want is a core allocation capable of delivering approximately 5% real returns while minimizing drawdowns across different market regimes. The regimes that are of particular concern are:
The goal of this exercise is not to build an Armageddon-proof portfolio. In the case of extreme tail events (nuclear war, zombie apocalypse, socialist revolution) your portfolio is going to be the last thing you’re worried about. And anyway, what you’ll really need in those situations are food, medicine and bullets.
The Permanent Portfolio
I think the permanent portfolio offers a solution. The investment analyst Harry Browne devised it specifically for robust performance across a range of different economic conditions. In its original form the permanent portfolio consisted of:
25% US Stocks
25% Long-Term Treasuries
The underlying intuition is a model of parsimony. This is a combination of assets where “something should always be working,” regardless of the macroeconomic environment. Long-term Treasuries and gold are less correlated and often negatively correlated with equities. Long-term Treasuries do well in deflationary busts. Gold does well in periods of high inflation.
I do have some quibbles with the permanent portfolio in its original form:
It holds too much cash.
It is under-allocated to equities.
It is strongly biased toward the US.
But perhaps we can address these issues through portfolio construction.
Analyzing The Permanent Portfolio
I used Portfolio Visualizer to run some analysis using historical data. I compared two different permanent portfolio implementations with a 60/40 allocation to US Stocks/US Treasuries. I set the portfolios to rebalance any time an asset class reached +/- 10% of its target weight.
I’ll walk through a couple observations in this post but if you’d like to explore the analysis yourself here is the link to exactly what I ran. (aside: I can’t recommend Portfolio Visualizer enough as a free analytical tool) Below are my three portfolios.
I was able to backtest these allocations back to 1986 with the available data. Unfortunately, the periods where the permanent portfolio really shines versus 60/40–the stagflation of the 1970s and the high inflation and interest rates of the early 1980s–lie outside this time period. If you drop the international equities you can capture the late 1970s and early 1980s, however.
Starting in 1986, Portfolio 1 rebalanced 7 times. Portfolio 2 rebalanced 9 times. Below is a growth chart comparison.
This 30-year period has been truly extraordinary for US stocks and long-dated Treasuries. It comes as no surprise that the permanent portfolios have lagged a 60/40 allocation. And, of course, the permanent portfolio with ex-US equity exposure lagged even more.
But you’re still getting your 5% annualized real returns, with milder drawdowns than the 60/40 portfolio. And in the bargain, you’re better protected from an inflationary regime than you would be with a 60/40 portfolio.
Obviously, if you don’t believe in allocating to ex-US equity you will prefer Portfolio 2 over Portfolio 1. I don’t share that belief, personally. But I certainly can’t prove US equity returns won’t continue to dominate going forward.
We can also look at returns over rolling periods, which paint a similar picture.
If you’re willing to use volatility as a quantitative proxy for risk, you can see the permanent portfolios are significantly more diversified in their sources of risk and return than the 60/40. Equity risk dominates the 60/40 allocation. Imagine the extent to which it dominates in a 70/30 or 80/20 split.
The tradeoff here is simple: give up some upside for a more attractive risk profile.
But what if you could juice the returns a bit?
Because this strategy is robust across market regimes it should also be fairly amenable to leverage. In an ideal world I’d take the more diversified flavor (Portfolio 1) and lever it something like 1.25x to 1.50x. This is the intuition behind risk parity: take a well-diversified portfolio with the risk exposures you want, then lever them to reach your target return. So instead of being limited to 33%/33%/33% you would be allocated maybe 45%/45%/45% for 135% notional exposure.
Unfortunately, as an individual investor it’s not straightforward to lever a portfolio. So, there are some implementation issues to work around. The simplest solution appears to be to use mutual funds or ETFs that apply leverage via either equity or Treasury futures.** This essentially allows you to “bolt on” gold and/or other alternative strategies without having to cut back on your equity or fixed income exposure. I may do a follow-up on this analysis exploring this form of implementation in more detail.
The Permanent Portfolio In A Barbell Portfolio
There are a couple less obvious, ancillary benefits to the permanent portfolio structure I want to mention in closing.
First, because of the attractive drawdown characteristics, it may obviate the need for large cash allocations (e.g. “emergency funds” or “cash buckets” for individuals). There are significant opportunity costs associated with large cash allocations, particularly in real terms.
Second, in keeping with the above, the permanent portfolio provides an excellent stable core around which to build a satellite portfolio of opportunistic investments. For example, at the wealth allocation level you could implement a structure where 70% of the portfolio is permanent portfolio, and the remaining 30% of capital is allocated to private market investments, or high risk/high return single hedge fund investments, or concentrated single stock positions. From a wealth allocation perspective you would be looking at something like 0% Protect Lifestyle / 70% Maintain Lifestyle / 30% Enhance Lifestyle.
In the above configuration, you would also likely be able to use the permanent portfolio as a source of liquidity during major market dislocations, to fund opportunistic investments at precisely the times when expected future returns are highest.
In my view, this strikes a nice balance between staying rich, maybe getting a bit richer but without dying trying.
Essentially, what you’re doing here is building a barbell portfolio. You’re using the permanent portfolio to set a floor for the value of the overall portfolio. You’re then taking the “excess” capital and buying call options with it.
There are other ways for individuals to implement a barbell portfolio structure. You could just use cash to create the floor. Except that’s an extremely inefficient use of capital, in my view. You could also use an annuity.
My quibbles with the annuity approach:
A fixed annuity with a modest inflation escalator leaves you vulnerable to inflationary booms and busts.
I am deeply suspicious of variable annuities–in fact, any insurance product with bells and whistles designed to “protect” you from various risks. The pricing of the bells and whistles is usually opaque and therefore not a good deal for the buyer. It is a timeless truth of economics that opaque pricing always and everywhere obscures profitability (see: healthcare; college).
No matter what route you go the insurance company will extract its pound of flesh.
You give up the ability to opportunistically redeploy capital from the annuitized core of your portfolio.
That said, I think buying a simple fixed annuity with an inflation escalator is a straightforward option for individuals who want to implement a barbell portfolio, and who are unable or unwilling to go the permanent portfolio route.
*I’d encourage everyone reading this to spend some time writing out your investment framework as explicitly as you can. This is your Investing Code. Once you’ve written down your Code, compare it to your actual portfolio and see if they match. The results of this exercise may surprise you. Incidentally, my friend Rusty Guinn wrote a phenomenal series of articles on Investing Codes and portfolio construction, called Things That Matter/Don’t Matter. I can’t recommend it enough. It touches on the issues discussed in this post as well as many, many more.
** Thanks to @choffstein and @EconomPic for their help conceptualizing this via Twitter.
A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.
Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.
The financial markets, too, are a kind of Skinner box.
Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?
We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.
Below is what an operant schedule of reinforcement looks like.
Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)
Bet on Momentum Factor -> SMALL REWARD (MAYBE)
Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)
The “lesson” here is very clear:
BETA IS ALL THAT MATTERS
BETA IS ALL THAT WORKS
This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.
Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).
The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.
This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.
The first self-archetype is merely the subset of James’ blooming, buzzing confusion that we classify into our mind’s “I.” It is extraordinarily hard to redraw this boundary later in life. Hallucinogenic drugs, intense stress, sensory deprivation chambers, or the rigors of meditative practice are usually required.
Freedom’s just another word for nothin’ left to lose.
Kris Kristofferson, “Me And Bobby McGee”
John Patrick Mason: Your “best?!” Losers always whine about [doing their] best. Winners go home and f*** the prom queen.
The Rock (1996)
This is going to be one of those abstract, philosophical posts. Consider yourself warned. However, portions will tie in rather neatly with investing. So you may want to stick around. I’m also going to try to write with as much clarity as possible here, because the concepts I want to explore in this post are fundamentally weird. In order, they are:
Identity functions as a psychic prison.
To have any chance of escaping the psychic prison of identity, we must to cultivate the ability to redraw the boundaries of the self.
Therefore, freedom is, at a fundamental level, the ability to participate as a principal in the process of creative destruction.
Let’s start at the beginning.
The Psychic Prison
There’s a well-known quote from the book (and movie) Fight Club: “the things you own, end up owning you.” The idea is that over time you settle into a pattern of consumption. You stagnate within this pattern. After a while, it is impossible to determine whether you define your pattern of consumption or whether your pattern of consumption defines you.
I’ll take this a step further and suggest the following: the thoughts you think, end up thinking you. That is to say, you think your “self” into existence.
We’ve all met someone who’s chronically negative. That person who’s always put upon, who’s always sick, who’s always short on cash or the victim of sinister forces outside her control. That person who spends her life lurching from one crisis to the next. At times it seems as though she’s the physical manifestation of negativity and misfortune in the world.
It seems that way because it’s true. That person truly is a physical manifestation of negativity and misfortune. While plenty of her misfortunes may well be beyond her control, she’s also co-creator of the misery in her life. She has chosen to define her life with negativity. Now, she may not see this as a choice. (In fact, she almost certainly does not) Stuff just happens to her. But allowing yourself to fall into the posture of a chronic victim is itself a kind of choice.
The thoughts you think, end up thinking you.
You are the co-creator of your lived experience.
If you find yourself attracted to value investing, and you come to identify strongly as a “value investor,” in addition to whatever financial returns you generate that identity probably gives you a sense of meaning and maybe even a sense of community or belonging (if you don’t see Berkshire Hathaway’s annual meeting as a form of religious pilgrimage I’m really not sure what to tell you). Your value investor identity also frames your worldview a certain way. It limits your worldview in certain ways. This can be a liability, if your value worldview is fundamentally misaligned with the prevailing market regime. In this case your identity may well turn out to be a form of maladaptation.
A static identity locks you into particular patterns of thought and behavior. These patterns are relatively straightforward for others to identify and exploit, whether in business, politics or investing.
This lock-in is what I mean by psychic prison.
Escaping The Psychic Prison
Escaping the psychic prison of identity is straightforward but not easy. All you have to do is redraw the boundaries of your identity.
This lies at the heart of zen practice, adjacent to the idea of non-attachment. After years of practice, a zen master might be able to completely erase his attachment to self–a process that might trigger a complete mental breakdown for someone unprepared for the experience. What might this feel like? Having not experienced the feeling of complete dissolution of self, I’m hardly qualified to describe it.
Fortunately, complete dissolution of the self isn’t required to break out of the psychic prison of identity. All that’s needed is the ability to consciously rewrite the boundaries of identity.
Meditation is one way to practice this. Another is acting.
Our value investor might begin working on his escape from the limiting aspects of that identity by play-acting at growth or momentum investing. This doesn’t mean completely abandoning the tenets of value investing. It merely means cultivating the ability to view the world through someone else’s eyes. It’s merely about wearing the mask of a growth investor. At least to start, anyway.
The things you own, end up owning you.
The thoughts you think, end up thinking you.
The masks you wear, end up wearing you.
Ultimately, there’s no difference between you and the masks you wear. You are the masks you choose to wear. For some this is a frightening possibility to consider. Particularly from a metaphysical perspective. However, it’s also empowering.
Remember, you get to choose the masks you wear. That’s the point of this post.
The Nature Of Freedom
True freedom is freedom from an arbitrary or externally defined definition of self. It’s engaging in the process of creative destruction.
Personal freedom is engaging in creative destruction at the level of the self. Economic freedom is engaging in the process of creative destruction in the external world. When I say engage in I mean engage inas a principal, as a force acting on the world around you. Like it or not, we’re all subject to the process of creative destruction. The difference between freedom and slavery is agency.
This is the reason I included that quote from The Rock at the start of this post. It cuts to the very heart of what it means to be free. Free people manifest their will in the world around them. Losers whine about doing their best.
The archetype of the chronically negative loser described at the beginning of this post is especially grim. Here is a person who cannot even rise to the level of whining about doing her best. All she can do is whine about being a victim.
By contrast, by this definition, Frederick Douglass was probably freer as a slave than most nominally “free” people are today. It’s not an accident that one of Douglass’s most famous sayings is the statement that “knowledge is the pathway from slavery to freedom.” There is a reason slave owners did not want their slaves to learn to read.
In this spirit I’ll close with an excerpt from Douglass’s speech, “Self-Made Men,” which I recommend you read in its entirety.
I am certain that there is nothing good, great or desirable which man can possess in this world, that does not come by some kind of labor of physical or mental, moral or spiritual. A man, at times, gets something for nothing, but it will, in his hands, amount to nothing. What is true in the world of matter, is equally true in the world of the mind. Without culture there can be no growth; without exertion, no acquisition; without friction, no polish; without labor, no knowledge; without action, no progress and without conflict, no victory. A man that lies down a fool at night, hoping that he will waken wise in the morning, will rise up in the morning as he laid down in the evening.
Faith, in the absence of work, seems to be worth little, if anything. The preacher who finds it easier to pray for knowledge than to tax his brain with study and application will find his congregation growing beautifully less and his flock looking elsewhere for their spiritual and mental food. In the old slave times colored ministers were somewhat remarkable for the fervor with which they prayed for knowledge, but it did not appear that they were remarkable for any wonderful success. In fact, they who prayed loudest seemed to get least. They thought if they opened their mouths they would be filled. The result was an abundance of sound with a great destitution of sense.