Total Stock vs. Small Cap Value/Emerging Split

[MediumTex]

And what are the non/less-volatile stocks?  It is also clear, by extension, that if one could find "volatile stocks" that would outperform, one might also underperform "the market" using those same stocks.  Just wasn't sure what these were.

Banks used to be considered low volatility stocks.  Now they are high volatility stocks.

Tobacco has its periods of low and high volatility, as do the drug makers.

The car companies?  Non-volatile some of the time, very volatile others.

How about old school technology like IBM?  Same story--volatility comes and goes.

Volatility visits every sector sooner or later.

[Roy]

Volatility visits every sector sooner or later.

Yes indeed.  And sooner rather than later, as magnificently demonstrated in flights. 

What were the volatile stocks you believe HB was referring to in his book (the ones that "move farther than the general stock market when times are good")?

[moda0306]

High vs. Low dividend yield maybe?

Growth Stocks?

[Roy]

High vs. Low dividend yield maybe?

Growth Stocks?

He does recommend some Growth funds.  And a Large Value fund. 

I suppose were he to edit it today, it would likely be the TSM, as Craig says. This has combined well with its asset classes over these 40 years, and the PP is dominated by non-stock classes anyway.  Though, I imagine even particular asset classes would have done well also, maybe better (I seem to recall Clive or Trev playing with equity asset classes for the stock portion over the same period).  But TSM is inexpensive, worked just fine, and to spectacular portfolio outcomes at times (like these past 3 years).

[Gumby]

The problem with using Emerging Markets in a Permanent Portfolio is that it's simply performance chasing, and nothing more than adding speculation (on foreign markets and currencies) into an otherwise neutral portfolio. That would easily break the warranty on a Permanent Portfolio.

In other words, the reason why HB never considered Emerging Markets is because Emerging Markets are not directly tied to "Prosperity" — one of the four pillars of the PP. Emerging Markets did their poorest from 1995 to 2000 — during what was perhaps the greatest 6-year stretch of prosperity, ever.



A PP that uses Emerging Markets might do very well over a 40 year period, but it may also very well be left behind during actual times of prosperity — which would be quite painful.

[moda0306]

Great point on 1995-2000 Gumby.  I didn't realize that.  Thanks for the info.

[Gumby]

The problem with using Emerging Markets in a Permanent Portfolio is that it's simply performance chasing, and nothing more than adding speculation (on foreign markets and currencies) into an otherwise neutral portfolio. That would easily break the warranty on a Permanent Portfolio.

In other words, the reason why HB never considered Emerging Markets is because Emerging Markets are not directly tied to "Prosperity" — one of the four pillars of the PP. Emerging Markets did their poorest from 1995 to 2000 — during what was perhaps the greatest 6-year stretch of prosperity, ever.
....snip

The performance of EM's over that period is entirely as you might expect.  Being foreign currency and somewhat commodity driven they're more like gold than stocks.  In times of USD crisis EM's might be expected to do relatively well for the offshore currency and commodity like qualities as can be seen from more recent EM performance figures.

Blended with perhaps SCV and you have a sort of 'neutral' holding or a mini-PP with SCV acting as the 'stocks' and EM as the 'gold'.

For a fair comparison you should really compare between two periods when both assets had achieved the same overall gain (or loss), unless that is you expect one of the assets to never re-align with the other in which case you'd just hold the better choice.

Given two assets that achieve the same gain between two points in time (such as over a period when they both achieved the same rewards), then holding equal amounts of both and periodically rebalancing back to equal weightings when deviations became apparent, has you add-low/reduce-high and will produce higher rewards overall than having held one or the other alone, and also likely do so with less risk (assuming volatility or standard deviation is considered as a measure of risk).  Having two assets that individually have relatively high volatility, but zig and zag in somewhat opposite directions has the effect of reducing the overall combined volatility, but you're rewarded on an individual 'higher risk' basis (average of the two gains).

That's all well and good, and I'm sure it would do well over the long run, but my point is that EM/SCV clearly doesn't represent Prosperity — which is likely why Harry Browne never considered it as a legitimate choice for the PP.

By replacing your Prosperity pillar of the Permanent Portfolio with a "mini-PP" you would not have done very well during the great prosperity of 1995 to 2000. That's the undeniable consequence.

I've been told that the most challenging part of holding the Permanent Portfolio is that you may be tempted to ditch the strategy during times of prosperity to chase higher returns. So, imagine holding the EM/SCV split in your PP from 1995 to 2000 and underperforming a traditional Permanent Portfolio when everyone else is making enormous amounts of money. It would be nearly impossible to stay the course. Not to mention, you would not be given the proper opportunity to re-balance large profits into key assets like Gold and Bonds in time for an oncoming recession.

[moda0306]

Since we have no decent TSM index in my 401(k), I've been using a lot of Emerging Markets thinking it's just "TSM on steroids," and it was basically just a more risky set of stocks but will make the same movement directions.

I am glad I now know that's not the case.

[Gumby]

Hi Gumby

By replacing your Prosperity pillar of the Permanent Portfolio with a "mini-PP" you would not have done very well during the great prosperity of 1995 to 2000. That's the undeniable consequence

As with the PP you have to consider the collective rather than the individuals alone

Small (Growth) and Value - combined SCV, might be considered as a combination of stocks (small) and LT's (value).  Each can do OK alone, as a pair they tend to have a degree of low correlation

EM's might be considered a form of gold play.

So a blend of 50% SCV, 25% EM and 25% 5 year treasury (as a 'cash' proxy)

...

produced some reasonable gains over the 1995 to 2000 period.

The ride was quite bumpy however, so an option might be to water that down by halving the amount of exposure in SCV and EM's to

...

Or perhaps even water down to a third and :

...

The water down to a third did relatively OK, but did have some real (after inflation) volatility during the 1970's which could have been reduced by taking some of the cash and investing in gold for a bit more high inflation/domestic currency crisis protection

...

That overall provided somewhat similar risk (few down years and down only a little in those years) and relatively consistent real gains over time.

I've been told that the most challenging part of holding the Permanent Portfolio is that you may be tempted to ditch the strategy during times of prosperity to chase higher returns. So, imagine holding the EM/SCV split in your PP from 1995 to 2000 and underperforming a traditional Permanent Portfolio when everyone else is making enormous amounts of money

Compared to the Coffee House (60/40 stock/bond type blend), having included SCV and EM's to me looks potentially less likely to have been capitulated than the PP, including over the 1995 to 2000 period.

You'll have to excuse me, but I can't follow any of that.

When you start including a handful of lengthy charts and using a dozen funds — including REITs and European stocks — in an allocation that's supposed to simply be SCV and EMs, my eyes glaze over. I was under the impression that this thread was simply about replacing the PP's stock allocation with a SCV fund and a EM fund, no? That's what I meant when I referred to your "mini-PP" analogy.

Put the charts away for a moment. If the Permanent Portfolio works because there are four assets where at least one will perform well during each of the four stages of the economy, can you explain — using language alone — how replacing the PP's stock allocation with a simple SCV/EM split will save my hide during times of Prosperity?

I don't see how you can when you look at 1995-2000.

[Gumby]

can you explain — using language alone — how replacing the PP's stock allocation with a simple SCV/EM split will save my hide during times of Prosperity?

No

I think what you've found is a nice diversified variable portfolio that has worked very well over long periods of time. I was under the impression that the SCV/EM split was an even 50/50, but if you've chosen to diminish the weighting of the EM down to 8.4%, I suppose that will improve your numbers for that period of prosperity. No one is doubting that it has done well over the long haul. And I'm sure it will do fine.

The reason I chose 1995-2000 is because it was a prosperity bubble. It was the run-up to the S&P 500 index reaching an all-time intraday high of 1,552.87 in trading on March 24, 2000. If that's not a perfect example of a period of prosperity, I don't know what is. Stocks represent prosperity within the PP, and therefore, the all-time high of the S&P 500 is easily explained as a product of that period. EMs did not do well during that period — which makes one wonder why it should be a part of a powerful prosperity allocation.

Which, again, brings me back to my point. You are so far unable to explain — in simple terms — how a PP with a SCV/EM stock allocation should perform during a period of prosperity. It just seems a bit irresponsible to recommend a rebalanced PP strategy to others if you can't easily explain how it will work in every economic environment. That, I feel, is the reason why HB never suggested it.

If your portfolio's prosperity pillar can't be explained, or doesn't exist, that's fine. To each his own. We don't need to keep going back and forth on this ad nauseum.  :)

[Lone Wolf]

In other words, the reason why HB never considered Emerging Markets is because Emerging Markets are not directly tied to "Prosperity" — one of the four pillars of the PP. Emerging Markets did their poorest from 1995 to 2000 — during what was perhaps the greatest 6-year stretch of prosperity, ever.

This is a very important point.  I had not realized what happened in 1995-2000 in EM.  If your stock allocation doesn't perform well during prosperity, the portfolio simply won't act like a "Permanent Portfolio" in the way that the 4x25 is designed.  The 4x25 has good, steady returns with low volatility.

Furthermore, there is an economic rationale for why 4x25 performs this way in all known economic conditions.  While I think that there is an excellent rationale for why SCV will perform well in times of prosperity (although I personally prefer "total stock market"), this rationale simply does not exist for EM.  EM might do "fine" in times of domestic prosperity but there's certainly no guarantee that this would be the case.  With gold probably doing terribly during those prosperous times, weak performance on the part of EM is likely to mean a much more volatile portfolio.

EM just doesn't seem like it fits in a "Permanent Portfolio", particularly for an investor that puts much emphasis on volatility.

[Pkg Man]

I initially had a small allocation of EM in the stock portion of the PP but based on feedback here decided to just use VTI, the S&P500, and a bit of a mid-cap index fund (the later two are in my 401K as there is no direct option for the total market; most of the stock portion is in VTI).

I like EM a lot and hold some individual stocks from EM countries, but will invest only only VP funds there from now on.

[Gumby]

Which, again, brings me back to my point. You are so far unable to explain — in simple terms —

In simple terms



For the explanation read Fama and French

For the record, what I actually said was...

Which, again, brings me back to my point. You are so far unable to explain — in simple terms — how a PP with a SCV/EM stock allocation should perform during a period of prosperity.

Prosperity, prosperity, prosperity, prosperity....prosperity. It would seem I can't repeat that enough.

The formula doesn't have anything to do with ensuring I'll have the most powerful stock allocation in my PP during times of "prosperity".

[craigr]

Please keep things civil.

[MediumTex]

Please keep things civil.

Ditto.

We are all friends here.

[moda0306]

I can see where Gumby's coming from.

Even though the mix you provided, because of the larger SCV piece, did well during the 1995-2000 stretch, because the EM part of it didn't do well, that does give people cause for concern as it's still a huge chunk of your prosperity piece.

For instance, if I were to (and I have, to some extent) suggest that other commodities besides gold should be used to diversify that piece, one could point to periods that gold performed much more in line with what a monetary metal should during times of inflation or even deflation... being invested in copper in 2008 would have been disastrous, while gold gained 4.5%.  This is because there are fundamental problems with other metals and how they behave on a macro-economic level.  Same could be said about different kinds of bonds and why/how they're unfavorable, even if they wouldn't have derailed the PP if used in limited portions, as EM are in your example.

Shouldn't we attempt to analyze EM the same way?  I feel its poor performance during 1995-2000 is a huge indicator that there is something fundamentally wrong with EM as it pertains to how it should be implimented in the PP, even if using it has proven ok in the past.

[Gumby]

Anyone who is considering using a SCV/EM split within their PP should realize that very few people actually have any money invested in that strategy.

Paul Boyer has done a wonderful job tracking the SCV/EM split within a Permanent Portfolio (which he has dubbed the "Paul Boyer Permanent Portfolio"). When I asked him about EMs during the late 90s, he was very up front about it — and I give him a lot of credit for his response.

Here's what he said:

It clearly wasn't a prosperous time for emerging markets. Yes, that was a more prosperous period for US Large Cap. At other times other countries and size companies will be more prosperous. Why not diversify?

Nonetheless, I do think most folks should just stick with the original HBPP and go with a total stock market fund. Perhaps that fund should even be a total global fund. I've studied the PBPP as more of an academic exercise to see if a small value and emerging market tilt can juice returns with low increase in risk. Sometimes it worked, sometimes as you point out, it did not work.

Invest at your own risk.

At the time he wrote that — this past October — he had yet to fully invest in his portfolio. My understanding is that he finally took the plunge just last month.

[MediumTex]

Anyone who is considering using a SCV/EM split within their PP should realize that very few people actually have any money invested in that strategy.

I'm surprised that this topic has gotten as much attention as it has.

Changing the PP stock allocation is similar to almost any other PP tinkering--it's probably not worth the trouble and may introduce additional levels of risk in the PP strategy that may not be obvious at the time that the tinkering takes place.

I think we can all agree that a simple U.S. stock index works fine in the stock portion of the PP.  I believe we can also agree that allocating up to 15% of the PP's stock allocation to an international index is probably not going to lead to a lot of future regret.

Beyond that, I would say just stick with the PP recipe and use the VP for investing in small cap value and emerging market funds.

Part of the appeal of the PP is that it is simple and one doesn't have to be a sophisticated investor to deploy it successfully.

[AdamA]

Does anyone think it may be worth it to replace an S&P or total market index with either a growth or value index?  I know HB's original rec was for a growth fund...right?

[Lone Wolf]

Does anyone think it may be worth it to replace an S&P or total market index with either a growth or value index?  I know HB's original rec was for a growth fund...right?

Total Stock Market or S&P 500 will work just fine.  These should generally have more attractive expense ratios and also eliminate the possibility of missing out on some sector that unexpectedly experiences more growth than had been anticipated.

In "Fail-Safe Investing" (my edition is from 2003), Browne recommended funds that emulate the S&P 500 while keeping expenses as low as possible.  It's reasonable to believe that Browne would have also thought Total Stock Market was a good option (if not better.)

Browne originally (in the late 80s) recommended picking volatile stocks.  In "Why the Best-Laid Investment Plans Usually Go Wrong" he recommended either high volatility stocks, mutual funds that invest in high volatility stocks, or warrants.  (I hadn't even heard of warrants before reading the book.)  Over time it became much easier to emulate the S&P 500 and he found that this worked just fine, so the recommendations from the 80s are obsolete now.

[MadMoneyMachine]

At the time he wrote that — this past October — he had yet to fully invest in his portfolio. My understanding is that he finally took the plunge just last month.

Yep, I took the plunge late 2010. I predicted that it would mark the peak of the PP and others should sell. :-)

But yes, I do invest in the "Paul Boyer Permanent Portfolio" because I believe that I want extra risk for my equities. I believe Fama and French when they say small cap value has more risk. And risk and return are generally correlated. I like Emerging Markets because it helps diversify globally and currency-wise. And the backtesting doesn't hurt. :-) I think I can stomach the non-correlation with S&P 500. And I tend to be idiosyncratic anyway.

I stick by my statement that MOST folks should just go US-TSM.

Of course another strategy might just be to increase the exposure to equities. As this posting showed, a 45% exposure to equities boosted returns 2% annually with 2% increase in risk (standard deviation).

[Lone Wolf]

But yes, I do invest in the "Paul Boyer Permanent Portfolio" because I believe that I want extra risk for my equities. I believe Fama and French when they say small cap value has more risk.... I think I can stomach the non-correlation with S&P 500.

I think that this summarizes the issue very well.  Fama and French demonstrated a premium on SCV and EM returns over time.  Furthermore, it's reasonable to believe that SCV and the general US stock market will correlate.

However, EM will not necessarily correlate with the US stock market.  This could mean funny behavior during "prosperity" in the US, likely proportional to the amount of EM held in the stock portion of the portfolio.

This means that replacing a portion of the stock allocation with Emerging Markets could yield greater overall Portfolio volatility.  While there may be other consequences as well, either positive or negative, this greater expected level of volatility seems like an intuitive one to expect.

None of this means that an SCV\EM mix is "bad".  On the contrary, anyone that has paid attention to the Paul Boyer Portfolio has noticed that it has done damn well over time.  I predict that it will continue to do well but will see more volatility than 4x25.  I think that this volatility will be caused by the EM holding.  Time will tell.

[moda0306]

LT Corporate bonds or Copper may be volatile, but there is a fundamental reason that they don't fit into the portfolio.  EM may have good overall returns (So do other assets not in the PP)  but that doesn't necessarily mean that it's going to give you the right volatility at the right time.  If the stock portion of the portfolio is supposed to capture prosperity (because the other assets tend to rise during some adverse macro-economic periods), then to try to diversify that portion into sectors that could do well during our currency collapsing or poorly in times of great American prosperity is like throwing copper into your gold portion, or TIPS into your cash.

Gold: Capture inflation through an almost pure monetary metal, so that during economic collapse its industrial value collapsing isn't a risk

LT Treasuries: Capture deflation with the most reliable borrower of the dollar in the world.

Stocks: Capture prosperity by betting on companies in your home-country (even though they do business abroad).

I'm not saying EM won't continue to do well.  Copper, oil, TIPS, corporate bonds, junk bonds, and gold stocks could all do extremely well also.  But they don't really belong in the PP.

[AdamA]

Ditto, Moda.

I'd add:

This issue of the total US market vs the S&P vs EM vs Pacific Rim vs Value vs Growth, etc is something everyone struggles with a bit when they first start thinking about the PP. 

This is b/c mainstream portfolio theory really focuses on this type of diversification, so no one wants to miss out on potential Value or Small Cap premiums, or when the Pacific Rim finally takes off again, or whatever may (or may not) happen in the future.  Basically, we all want to reach for a little more yield. 

My advice:  instead of reaching for yield, reach for safety and low costs.  Think about things like the safest way to hold gold, keeping as much of your cash is US Treasuries as possible, maintaining a low cost, tax efficient account (which gets tougher and tougher the more you slice and dice). 

EM's and SCV's will cycle like anything else.  Everyone knows about the potential "bonus" you get from owning these, and you know what happens when everyone knows something...

Same for copper and other commodities, and even real estate.  These are all recently (last decade or two) popular "investments" so it's hard to ignore them (and probably exactly why you should). 

Adam