Sunday, October 24, 2010

Is Fail-Safe Investing Possible?

I read a book this week called Fail-Safe Investing: Lifelong Financial Security in 30 Minutes by Harry Browne. Over the past five years or so I've read dozens of books on conservative investing--how to build wealth slowly rather than try to get rich quick--and out of all of them, Fail-Safe Investing strikes me as one of the most unique in its philosophy and practical recommendations.

The first thing I liked about this book was how short it is. The hardcover version I borrowed from the local library measures only 5.5 by 7.5 inches and is 167 pages, including appendices. I read the entire book in a little over an hour. (I'm a slow reader--so sue me!) One of the book's key themes is simplicity, so it makes sense that the book is so short.

The second thing I liked about this book was how it does not rely as heavily on past performance and backtesting as do most other conservative investing books I've read. It relies just as much on common-sense ideas rooted in a realistic acknowledgment of the world's extreme uncertainty. Although the book never mentions Austrian economics specifically, it seems like the economic ideas alluded to in the book were probably influenced by the Austrian school. (This would make sense, because Browne was an advocate of libertarianism and Austrian economics and was the Libertarian Party's presidential candidate in 1996.)

One of the key themes in Browne's book is that the world is far riskier and more uncertain than most of us think. This idea has since been expanded and refined, with plenty of real-world evidence, by writer Nassim Nicholas Taleb in The Black Swan: The Impact of the Highly Improbable and by the famous mathematician and founder of fractal geometry, Benoit Mandelbrot, in The (Mis)behavior of Markets: A Fractal View of Financial Turbulence. Due to this extreme uncertainty in the world, Browne contends that an investment portfolio should be structured to do well in all possible economic conditions.

According to Browne, the predominant economic condition at any given time is one of the following four:
  1. Prosperity
  2. Recession
  3. Inflation
  4. Deflation
Browne then explains that during each of these four economic conditions, there is a corresponding asset class that tends to perform relatively well. They are (respectively):
  1. Stocks
  2. Cash
  3. Gold
  4. Long-Term Bonds
Since it is difficult to predict consistently which of the four economic conditions (prosperity, inflation, recession, or deflation) is going to dominate in any given year, Browne suggests that a truly "bulletproof" portfolio should allocate 25% to each of the four asset classes listed above. Weaknesses in one or more of the asset classes should then almost always correspond to strengths in the other asset classes. Surprisingly, the asset classes doing well at any given time tend to more than compensate for the asset classes that are lagging or even getting hammered. At the end of each year, one simply re-balances the portfolio (i.e., sells some of the assets that did well to buy some of the assets that did poorly). One of the key advantages of an approach like this is its supreme simplicity: the 25% target allocations never change over time.

Take a look at this table of historical returns of the Permanent Portfolio and its component asset classes between 1972 and 2008. Notice how the Permanent Portfolio achieves a positive average rate of return without the wild, gut-wrenching year-to-year swings seen in some of the four component asset classes such as stocks and gold. That table, as well as the book Fail-Safe Investing, assume only U.S. stocks, U.S. bonds, and U.S. cash, but it seems like the Permanent Portfolio could achieve even more diversification by using global stocks, global bonds, and global currencies instead of the exclusively U.S. kinds.

My views on investment approaches have evolved over the years, and I'm sure they will continue to evolve. But right now, I see the Permanent Portfolio as an attractive option in this world filled with uncertainty, volatility, and unpredictable government mandates. Safe, stable, and simple. Perhaps such a thing as "fail-safe investing" just might be possible, after all.

[Update, 11/5/2010: After learning a bit more about the economic basis of the Permanent Portfolio, I should probably revise my statement above about the possibility of adding even more diversification by holding global stocks, global bonds, and global currencies. While I still think it may be a good idea to diversify globally with stocks (the U.S. won't always be the world leader in economic growth and prosperity), I now see why Harry Browne did not recommend diversifying globally with bonds and cash. In two words: credit risk. The point of the bond and cash portions of the portfolio is to provide safety during periods of deflation and recession, respectively. But in deflationary periods and recessions, the likelihood of business and government defaults goes up.

In such an environment, credit risk is minimized by holding bonds and cash issued by one of the only entities in existence that can feasibly tax and print money to pay off its massive debts without going into default: the U.S. federal government. That is why Harry Browne recommended holding Treasuries for the bond and cash portions of the Permanent Portfolio. Holding global bonds and global cash would add some diversification, but only at the cost of introducing unwanted credit risk into the portions of the portfolio that are supposed to do the heavy lifting during the periods of high default rates. Not the best idea. Yes, the credit rating of even the U.S. government is starting to look shaky these days, but that's why the Permanent Portfolio allocates 25% to gold: to hedge against U.S. currency devaluation.

Another way of explaining it is this: Once you've seen one fiat currency, you've seen 'em all. They all tend to lose value over time due to inflation caused by the countries' respective central banks. So why even bother diversifying one's cash holdings globally? Global business growth, yes--I want to be a part of that, which is why I invest in global stocks--but global currencies themselves? What's the point? I use my native fiat currency only because I have to, and I hedge it using gold, the original currency... the hardest currency there is.]