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Permaeverything, inflation and alternative assets

Hello Cullen,

I've just read your article on "Permaeverything" and since I'm also a fan of the idea of an All-Weather portfolio, I decided to ask you whether 1) you hold any specific asset with inflation protection in mind and 2) if you hold any other assets other than stocks, bonds and cash.

When I was researching the All-Weather approach as presented by Ray Dalio I noticed he suggested the typical balanced portfolio can perform relatively well during periods of higher than expected growth (because of stocks), lower than expected growth (because of bonds) and lower than expected inflation (also because of bonds), but not in periods of higher than expected inflation since neither stocks nor nominal bonds perform very well under periods of higher inflation.

He therefore suggests including some assets for inflation protection, namely inflation protected bonds or even gold, which he recently advocated again. I know you're not a fan of the barbarous relic, but what about inflation protected bonds? Does you ideal "Permeverything" portfolio include them or any other asset with inflation protection in mind?

 

Thank you for your time in advance.

P.S.: I'm currently trying to build my own Permaeverything portfolio (with Permaeverything in my case meaning a portfolio which I do not fell the need to constantly tinker and which provides reasonable long term purchasing power preservation without excessive short-term risk), which is currently 60% stocks, 30% nominal bonds and 10% cash and does not satisfy me entirely at the moment. I'm currently battling internally as to whether it would be a good idea to include 10-20% in inflation protected bonds or other alternative assets, even when I live in the eurozone and inflation here is nowhere to be found; hence me asking.

Hi @mftg,

Dalio advocates a high number of uncorrelated assets. I believe he usually tries to use as many as 15. This is extremely complex for the average person and probably unnecessary. It also churns up lots of taxes and fees which kill most retail investors.

I don't mind the original Harry Browne Permanent Portfolio. But I've never loved holding gold. Or at least I never felt like it was necessary and possibly carries huge downside risk in the case that people lose faith in its monetary value. I guess the opposite could also happen? I don't know. But at the end of the day it's just a commodity to me and commodities shouldn't appreciate more than the rate of inflation so....

To me, stocks are the absolute best inflation protector because corporations set prices (the cost of goods) and try to sell them at a profit. So you should earn a bit of an inflation premium owning stocks via an index fund because you're positively skewed towards the corporations that having long-term pricing power (because index funds shed losers and buy winners).

60/40 is a fine type of Permanent Portfolio. I personally think it's too overweight stocks at times and I think the Bond Aggregate's bond holdings are somewhat silly, but those are somewhat active tweaks I make in the process that might or might not add some incremental returns.

To me, the most important part of all of this is understanding that you need to control what you can control:

1) Your behavior (which is mostly a function of how much risk you take via your allocation).

2) Taxes.

3) Fees.

If you get those three things right you'll do just fine. No need to torture #1 like so many people do....

Good luck!

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

I think Dalio is being disingenious because his idea of assets is essentially custom trading systems that have low co-variances with each other.  So there really aren't 15 asset classes out there, only three.

OTOH, inflation gets thrown around as far too binary a bogeyman in my experience.  It would be helpful to view it more along the lines of normal inflation, higher inflation, unexpected inflation and hyperinflation because different assets fit ideally into those buckets.  And in some of those buckets there is systemic risk where something like TIPS would expose you to more risk instead of reducing it.

Just keep in mind that the 70's was an interesting combination of variables that had an outsized effect on gold.  Next time history repeats (but not exactly!), the market may decide it has a fetish for something else instead, like 3D printed Snuffleupaguses.  So there's plenty of smart diversification you can do in these buckets besides just the barbarous relic.

 

Thank you for your replies.

60/40 is a fine type of Permanent Portfolio. I personally think it's too overweight stocks at times and I think the Bond Aggregate's bond holdings are somewhat silly, but those are somewhat active tweaks I make in the process that might or might not add some incremental returns.

Cullen, do you think 60/40 is too aggressive for someone who may want a stable enough portfolio that could enable withdrawing the money in a short time period (1-2 years) if needed without running the risk of a substantial loss?

I also think 60% stocks is a little too high, but on the other hand bonds are at all time highs (especially in Euros) and therefore have more downside than upside, besides greater convexity (which you've written about). Therefore, I also see more risk than usual in the portfolio's bond portion.

My ideal portfolio is one that provides reasonable long term capital preservation whilst still enabling me to withdraw money for expenses I may come to have in the short term (house and car downpayments or an MBA, for instance) without running the risk of withdrawing at a substantial loss.

 It would be helpful to view it more along the lines of normal inflation, higher inflation, unexpected inflation and hyperinflation because different assets fit ideally into those buckets.  And in some of those buckets there is systemic risk where something like TIPS would expose you to more risk instead of reducing it.

I've come to realise that what matters most is not the level of inflation, but unexpected changes in the level. Since asset values reflect discounted cash flows (for cash flow generating assets), any asset i buy now will have implicit an expected inflation level, which can be higher or lower. What will lead to price changes in those assets are changes in those inflation expectations, with different assets responding differently to that.

As for TIPS, you mean TIPS being counterproductive in a deflationary scenario, such as in a depression? I believe in such a scenario real yields would also come down, so the net effect on TIPS could be hard to assess. In any case, nominal bonds should do best in such a scenario, since if both real yields and inflation fo down, nominal yields go down twofold.

The riskiness of 60/40 is one of the holy grail type questions.

My view is that 60/40 is not very risky in the long-term, but can be very risky in the short-term. So, eg, in 2008, a 60/40 falls 35% and recovers within 3-4 years. If you're close to retirement or relying on a stable income then this could be pretty traumatic in the short-term. But it's much more complex than that. Eg, a 60/40 might generate 5% returns per year, but let's say you don't need that much. Well, this is where financial planning comes into the equation. Let's say you only need 3% returns to meet your withdrawals and sustain a sizable nest egg that you'll outlive. Then you don't need the risk of 60/40.

This is the problem with so much of asset management. Most people are just trying to maximize returns without realizing that they're often maximizing risk which might actually reduce returns by creating behavioral risk. So, I always tell people it's useful to be informed about both - planning and investment management. That's how you really lock in the appropriate portfolio.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

No what I mean is the systemic risk...  think Argentina or worse.  At a certain point, government paper becomes useful as toilet paper and that includes TIPS.  But on another note TIPS actually are pretty bad for deflation protection since the principal can be eroded.  I-Bonds are far superior in that respect.

The overall message is, I think, have a wide variety of asset classes and sub-investments in an all weather portfolio, both inside and outside the system, roughly weighted by their probability of occuring.  Most people don't even have an earthquake kit, so you'll be far ahead of the game just being slightly better than average.