The Investment Strategy That Actually Made Money in 2008

October 06, 2011

Last week, I wrote about some common ways to diversify your investments and make sure you don’t get caught up following the herd into the vicious “greed, hope, and fear” cycle that can lead to buying high and selling low. But even if you followed one of those strategies, you still probably haven’t been too happy with your portfolio’s performance lately. Your “early retirement plan” may have started looking like the “never retirement plan.” Is there a way to earn that 8-10% average return without all that risk?

The late investment adviser and author, Harry Browne, would say so. In his book, Fail-Safe Investing, Browne championed a “permanent portfolio” concept that he predicted would earn between 8-10% a year in all types of market environments with minimal risk. The basic idea is to simply divide your portfolio equally between stocks, long term government bonds, cash, and gold, and then re-balance it once each year regardless of your age or risk tolerance.

That may sound pretty crazy by conventional standards, but the long-term returns seem to back him up. From 1972 (when gold was taken off the fixed exchange rate and allowed to float in price) until 2008, the portfolio earned an average of 9.7% a year while the total stock market index earned about 9.2%. It then went on to earn 7.8% in 2009 and 14.5% in 2010. Even more impressively, the worst year was a loss of only 3.9% in 1981. In fact, the portfolio was actually UP 1.8% in 2008.

The trick is that each part of the portfolio does well during different types of economic environments so that the losses in one area are more than offset by gains in the other. Think of it as traditional diversification on steroids. When the economy is doing well, so do stocks. When the economy is in a deflationary recession (as it arguably has been the last few years), long term bonds do well (as they have been). When the economy is experiencing inflation, gold does well. When the economy is in a “tight-money recession,” nothing does well, so the cash helps stabilize the portfolio.

So what’s the catch? Well, first the permanent portfolio will lag when the stock market is doing really well so you’ll have to be satisfied with that 8-10% return when your neighbor is earning 20% during good times. (You get to gloat during the not-so-good times though.) Second, while the overall portfolio has been pretty steady, each component is really volatile. This means you’ll have to be able to re-balance from an area doing extremely well to one doing extremely poorly. In addition, the portfolio has never been tested during  a period of low but rising interest rates that we may be experiencing soon.

Implementing it could be a little tough too. That’s because gold and long term bonds are hard to find in the 401(k) plans that people have most of their investments in. You may have to purchase them in IRAs or taxable accounts instead. This could make an otherwise simple portfolio more complex to manage.

While there’s no guarantee that it will continue to do well, the permanent portfolio’s focus is on minimizing risk while still earning a decent return. That might sound good if you are a conservative investor. But what about those of us who want to primarily maximize returns while still keeping risk low? Next week, I’ll discuss one way to look for funds that could outperform the market without taking too much risk.