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"It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change."

-- Charles Darwin

About 25 years ago, Harry Brown came up with one of the most phenomenal investment ideas of the century. At a time when typical investment advisors were recommending portfolio mixes of as much as 70% stocks, with maybe 25% bonds and 5% Gold, Brown suggested an equally balanced mix of 25% each combined with 25% cash. He called it the Permanent Portfolio, and this strategy stomped on almost all others because Gold and Bonds actually outperformed stocks throughout the entire period of more than 2 decades.


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Now you can buy an ETF to replicate the Permanent Portfolio (PERM), which should be the first tip off that the strategy has probably already seen its best days. When Brown first described his strategy, Bonds yielded 15%, stocks were about as cheap as they had been since the depression and the real-price of gold was as low as it had ever been since being allowed to float freely against the dollar. Reams of academic research have more than amply demonstrated that if you start with a high price, you will get very much lighter returns at the end of any given decade than if you had started with a low price, and all of the assets on Brown's portfolio are prohibitively expensive today. It's not actually rocket science.

Stocks - The price/trend earnings ratio has a better ability to explain subsequent returns than any other valuation measure, and according to this measure, the expected return on U.S. equities for the next decade is negative.


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Bonds - At current yields, a 10-year bond will lose money on the year if the yield rises by more than 20 basis points. The typical fluctuation per weak is 13 basis points, and real yields are negative, so unless inflation falls to just about zero and stays at zero for 10 years, bonds will lose money.


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Gold trades at the highest price in real terms since it was allows to float in 1969.


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Adaptation

Today it is much more difficult to find cheap assets that have the same characteristics of those in the permanent portfolio, but we have several advantages that Brown could never have envisioned. The proliferation of exchange traded funds makes it possible to search the world over for cheap assets in every part of the world. If we don't want to buy any of them, inverse Index ETFs make it just as safe and easy to sell almost any of them short. Trading costs have collapsed, while volatility has increased making it far more profitable to increase the frequency of trading, and computer simulations enable U.S. to identify and adapt to patterns of behavior that Brown could never have detected.

Actually, this kind of is rocket science. By employing a combination of very long-term valuation and short term technical models that can go either long or short any of the three risk assets, Bonds, Stocks, or Gold, we have been able to model an eight-fold increase in the returns that could have been achieved with the permanent portfolio from 1969 to 2012.


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Even though we have turned Brown's framework completely on his head, we have not abandoned it. Brown's underlying concept is still important in framing the way we allocate assets within the guidance of the models, manage risk, and adapt to change. His underlying thesis was based on three principals:

  1. Investments were influenced by four factors: economic expansion and contraction, inflation and deflation.
  2. No one can predict which combination of these scenarios will dominate over the next decade, so we needed to have hedges in place for all of them.
  3. Each hedge must be as volatile as possible so that when it is working, it has the power to overcome all of the others that will not be working.

These premises still drive every aspect of our portfolio allocation strategies as much today as ever, but we are adapting new tactics in the face of new facts. To Brown's guiding three principals, we have added 3 more:

  1. Purchasing over-valued assets can do great harm to your portfolio no matter what.
  2. Brown had only one asset for each risk category. We believe the world has become more complex and that such simple solutions will be less available.
  3. Asset classes become over-valued or under-valued with greater frequency than in the past necessitating a slightly more active approach to investments.

For example, Brown considered U.S. equities to be the only necessary exposure to economic expansion. He did not predict that there would be a bubble in equities or that it would become so easy to move in and out of foreign equities. While U.S. equities are demonstrably too expensive to deliver the kind of returns we expect from our allocations to growth, there are hundreds of other equity markets to choose from, and many of them are very cheap. The entire Japanese equity market, for example, trades below its net asset value, and earnings have been artificially depressed by natural disasters. Japan still is home to hundreds of companies that the world economy cannot run without, and the currency is very over-valued. We think Japanese equities, if hedged for the currency exposure, could easily double even in the event that U.S. equities decline. There is no need for complicated currency transactions. DXJ gives you exposure to Japanese stocks and hedges the currency for you.


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Even if Gold is too expensive, there will always be some commodity somewhere in high demand that experiences shortages because of bottlenecks in supply. Most of the commodities are now represented by ETFs or if not, by very solid producers whose equities are listed on a common exchange. Natural gas suppliers have finally begun to curtail production, and speculators are massively short the commodity. Uranium production is already below current demand and the more countries study the Fukushima accident the more they are going to conclude that nuclear power is actually very safe.


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Always Hedge

Although we are advocating the frequent and liberal shorting of numerous asset classes, what we are doing is the opposite of what a typical aggressive hedge fund might do. If we short bonds, for example, that does not count as our deflation exposure, but rather, it is a substitute for our expansion, or equities exposure. It would be very unusual for U.S. to buy equities and short bonds at the same time even though our models might often call for such a position. When Nick Leeson caused the collapse of Barings Brothers, one of the oldest financial institutions in the world, he was buying Japanese equities and shorting bonds. This is why the following paragraph contains the most important advice that anyone can ever give you:

Never assume that you are going to be right about anything.

Our approach requires that we always have at least some exposure to all four categories of risk. So, if our models call for being long equities and short bonds, we would choose the one of the two that we felt had the best long-term return potential or had the fewest alternatives. For example, if we short bonds as a bet on expansion, we might also short equities for protection against deflation even if we expect equities to go up! This may be counter-intuitive to many people. If you short bonds because you think there will be growth, why would you short equities? The reason is that no matter how smart you are and no matter how hard you work at it, you are going to be wrong fairly often anyway.

Whenever there is a crises, two things happen when you are hedged that don't happen when you are not hedged. The first is that you barely notice it and don't have to do anything about it. You already have done everything you needed to. The second is that you start to view every crisis as an opportunity instead of a disaster.

Hedging is not the same as diversifying. When you diversify your equity positions, you do things like buying foreign equities or small cap equities. These may smooth out some rough edges of your returns, but they are going to move in the same direction as your U.S. stock portfolio most of the time. When you hedge, you buy things that will actually go down if your main thesis is correct. This is the hardest thing to do for most investors. You want to think that you are smart and can make a lot of money by being right all the time and hedging only dilutes your earnings. The problem is that everyone is wrong some of the time, and truth be told, most people are wrong most of the time.

Unlike Brown, we may often weight each category according to our best judgment, but we never alter the basic structure of the portfolio by very much. Instead of 25% for each category, in extreme circumstances, we might move to as much as 50% or as little as 10% for any one category, but there will always be exposure to all categories of risk. More often, we will move the weightings by less than 10%.

Source: Turning The World's Most Successful Investment Strategy On Its Head