Gyroscopic Investing

MachineGhosts' comments on improving the PP portfolio got me thinking about cash allocation. My belief is that the non risky asset portion (CASH- up to a point) should be separated from the risky asset allocation. While the 25% allocation to Stock, Bonds and Gold seems reasonable(not necessarily optimal as has been pointed out by others in terms of Returns, Sharpe ratio and DrawDowns) the allocation to CASH is a personal one determined by one's degree of risk aversiveness, needs, requirements for emergencies etc. Under this scenario the 25/25/25/25 is actually a predetermined  allocation of 75% to risky assets(appropriately allocated, i.e. 1/3 to each) and a choice of 25% for an individual without regard to their circumstances. People may instead choose to allocate 90/10 (Risky/"riskless") or 75/25 as HB has chosen or be even 10/90 if one's personal needs or situation are different. Of course HB's advice to keep the 1/3 allocation to the risky side is still remains a good one as a permanent choice.

I am curious to know what others think.

It works pretty well as it is. The 25% in cash makes the bond duration effectively 1/2 as volatile as the bonds alone would be. If you take the cash down too low then the bond volatility could be painful.

I thought volatility was desired?

beafet wrote: I thought volatility was desired?

Asset volatility, not portfolio volatility.

Clive,

i think You give the US$ too much credit...the most recent default was when Nixon closed the gold window

I think too often people fall into the trap of seeing cash as something that just waters down the portfolio. To some effect it does water down the portfolio because it has much lower volatility, but it also is a good diversifier.

The returns from cash are not consistent over long periods of time, and the variability of its returns has low correlation to stocks, long bonds, and gold. Please see 1981. The Fed has the power to suck money out of the market, hurting all asset classes except for T-Bills and other high quality short term debt.

Clive pointed out that in the Brazilian PP this year, cash has done best with +11%.

It's not 25% "Cash" but "Cash AND cash-like instruments"..  i.e. Cash, CDs, money market funds, short-term bonds, Dollar index, etc.

Thanks for all the varied replies. A few points that were reinforced for  me were:

1. It is not the individual asset returns and volatility  that matter but the total return and volatility. So impressive results for any individual asset is less important at least for me.

2. As MachineGhost has reported the 41/31/26/0  for stocks/Bonds/Gold/Tbills appears to be optimal for the periods that he considered. This may not hold for the future but it may be useful to know how much this varies for different 5,10 or 25 year or more rolling periods depending on your time horizon. By optimal I am using the Sharpe ratio which is defined as Expected value of (Port Return - Risk Free return)/SD of Port. This is the revised version. The original was (Expected(Port Return)-Risk Free Return)/SD. Slight technical variation. While Sharpe is not perfect it is arguably the best indicator we have so far. Superb return without mentioning the volatility is of less value.

3. Picking an optimal point only chooses the proportion of the risky assets. The Cash portion is  not exactly risk free as has been pointed out - there is clearly Inflation risk. However for our purposes and for the most part it can be considered risk free to the extent that we are almost certain to get the specified interest and the principal back when dealing with short term insured and/or Treasury instruments.

So, given the above, my view still is to get the optimal allocations for Stocks, Bonds and Gold.  After that pick the amount you want to keep in CASH(and I do mean CDs, Bills, MM funds etc as has been clarified by one of the respondents). The CASH can be picked based on personal requirements and does not change the Sharpe ratio which is the slope of a straight line joining the optimal point to the point(Risk Free return,0) for a (Return, SD) graph. Your choice does of course change the Return and volatility to be expected. If you need 25% CASH this method boils down to want HB has advocated.

In passing, I am hoping HB will not become religion and will be used as a source of prudent advice which needs to be continually challenged. I was reminded of this by a colleague who sent me the following quote:

     
“Do not believe in anything simply because you have heard it. Do not believe in anything simply because it is spoken and rumored by many. Do not believe in anything simply because it is found written in your religious books. Do not believe in anything merely on the authority of your teachers and elders. Do not believe in traditions because they have been handed down for many generations. But after observation and analysis, when you find that anything agrees with reason and is conducive to the good and benefit of one and all, then accept it and live up to it.”?
Buddha - 563-483 BC

gap wrote:      
“Do not believe in anything simply because you have heard it. Do not believe in anything simply because it is spoken and rumored by many. Do not believe in anything simply because it is found written in your religious books. Do not believe in anything merely on the authority of your teachers and elders. Do not believe in traditions because they have been handed down for many generations. But after observation and analysis, when you find that anything agrees with reason and is conducive to the good and benefit of one and all, then accept it and live up to it.”?
Buddha - 563-483 BC

 that reminds me of my current signature quote  "Belief is the death of intelligence. As soon as one believes a doctrine of any sort, or assumes certitude, one stops thinking about that aspect of existence.”?
R A W

Clive wrote:

People may instead choose to allocate 90/10 (Risky/"riskless") or 75/25 as HB has chosen

I suspect Harry might have considered the PP to be more of a 25/75

From Fail-Safe Investing :

Here are some alternative approaches. None is as safe as the Permanent Portfolio I’ve recommended. But you can use one of them if you find the Permanent Portfolio too difficult for you — or if you need to do something temporarily until you have the time and opportunity to set up a true Permanent Portfolio. In order of safety, they are:
1. Buy shares in the Permanent Portfolio Fund, a mutual fund that diversifies among the Permanent Portfolio investments (plus a few others).
2. Put all your savings in U.S. Treasury bills. A bank or stock broker can arrange this for you.
3. Divide your savings between two or three money market funds that invest only in Treasury bills.
4. Divide your savings among savings accounts at three or more commercial banks.

I think this quote from HB is very telling. He didn't have much confidence in growing your money vs. saving your money.

Thank God the man had the wisdom to look past his distaste for government and see the PP through what could have been a very hazy political bias.

In 2008 investors re-learned that cash actually is a very powerful diversifier in a stock portfolio. 25% may seem like too much to some, but for a retiree or someone near the end of their working career a big cash buffer is essential. It helps ride out market storms and manage living expenses.

When stocks and banks took a nosedive in 2008 I was very happy to have a big cash allocation that was in stable and safe T-bills.

There is no religion about Harry Browne. I looked at his advice with a very skeptical eye and basically the 25% split works very well. Trying to change it to chase extra return takes on additional risk. As long as investors remain aware of this there isn't a problem. But if we get really wild swings in the market again that cash allocation is going to start looking really good!

See my post about a risk parity HBPP.  Bottom line is that on a real return basis, a risk parity HBPP without ST bonds earns .50% CAR less than the HBPP.  So, apparantly, the ST bonds do some good over time.

MG

gap wrote: MachineGhosts' comments on improving the PP portfolio got me thinking about cash allocation. My belief is that the non risky asset portion (CASH- up to a point) should be separated from the risky asset allocation. While the 25% allocation to Stock, Bonds and Gold seems reasonable(not necessarily optimal as has been pointed out by others in terms of Returns, Sharpe ratio and DrawDowns) the allocation to CASH is a personal one determined by one's degree of risk aversiveness, needs, requirements for emergencies etc. Under this scenario the 25/25/25/25 is actually a predetermined  allocation of 75% to risky assets(appropriately allocated, i.e. 1/3 to each) and a choice of 25% for an individual without regard to their circumstances. People may instead choose to allocate 90/10 (Risky/"riskless") or 75/25 as HB has chosen or be even 10/90 if one's personal needs or situation are different. Of course HB's advice to keep the 1/3 allocation to the risky side is still remains a good one as a permanent choice.

I am curious to know what others think.