Backtesting Browne’s Permanent Portfolio Theory

Does a portfolio good for any seasons – without change the weights and the asset allocation – exist?

This is the question any lazy investor asks itself. The Harry Browne’s answer, an american investment adviser died in 2006, would have been: yes, the Permanent Portfolio (PP)!

The PP was created by Browne in 1981 and it suggests simply to build an equally weighted portfolio composed of stocks, long term bonds, cash and gold; this allocation provides protection as simple as effective when the economy moves through economic cycles (the so called “Kondratiev waves”). The PP has the objective to exploit every scenery: prosperity with stocks, deflation with bonds, inflation with gold and recession periods with cash.

Harry Browne believed no matter what happens in financial markets because, for sure, at least one of the assets in the PP will be doing well and in this way we can prevent the portfolio incurs consistent losses.Saying in his own words:

The portfolio’s safety is assured by the contrasting qualities of the four investments – which ensure that any event that damages one investment should be good for one or more of the others. And no investment, even at its worst, can devastate the portfolio – no matter what surprises lurk around the corner – because no investment has more than 25% of your capital“.

How this portfolio worked in the past with respect to the market?

If we compare the PP with the S&P 500 index in the last 40 years, we can note that the CAGR (compound annual growth rate) of the PP is about 9%, 1.5% less than the return of the S&P 500. In terms of returns the PP does not seem the best solution but its strength is to prevent downside shocks so we should consider the volatility and compare its Sharpe Ratio or, even better, the Sortino Ratio with that of the index. Doing that, we discover the two ratios are much better for the PP than the index; so, even if the PP has not produced outsized gains, it had a better performance considering the risk.

We can now try to stress the PP considering the inflation: the years of the 1970swere a periodof extremely high inflation level in US. Taking into consideration that period in order to do a backtest and show the benefit of the smoother returns provided by the PP,one notes that, even with withdrawals, the worst drawdown for the PP is less than 10% compared to over 50% for the S&P 500. Even in this case, the Permanent Portfolio beat the considered index.

The PP strategy works very well thanks to a deep diversification and, even if a correct benchmark is hard to find because of the portfolio composition, it appears the best solution for a lazy investor or as core part of much more complex portfolios!

 

Authored by: Luigi De Luca

Advertisements