Opportunity Knocks

The Reality:

The mass of men lead lives of quiet desperation.

~ Henry David Thoreau

The Opportunity:

When you feel in your gut what you are and then dynamically pursue it--don't back down and don't give up--then you're going to mystify a lot of folks.

~ Bob Dylan

The Permanent Portfolio

The more I learn about Harry Browne's "Permanent Portfolio" concept, the more sense it makes, and the more I like it.

The Crawling Road blog has some informative posts relating to Permanent Portfolio basics, and the site also contains a good discussion forum with separate forums dedicated to each of the four asset classes of the Permanent Portfolio (stocks, long-term bonds, cash, and gold) as well as the Permanent Portfolio as a whole. Check it out.

I also encourage you to check out Harry Browne's book Fail-Safe Investing to learn about the Permanent Portfolio straight from the man who first came up with it. If it's not at your local library, the electronic version costs only about $10 to download--so sacrifice a couple of lattes if necessary so you can learn about this simple, logical, Austrian-inspired approach to asset allocation.

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.]

Mexico Considers Legalizing Marijuana

Looks like Mexico is starting to debate legalization of marijuana as Californians gear up to vote on that same issue this November. On both sides of the border, people are slowly coming to the realization that prohibition simply does not work.

Risky Business

In his 2007 book The Black Swan, author and former Wall Street quantitative trader Nassim Nicholas Taleb writes that life is far more uncertain than most people realize, and they therefore unwittingly take on far more risk than they intend to. Some of those risks are completely unforeseen and carry massive consequences--so massive, in fact, that they can sometimes dwarf the consequences of practically everything else. Taleb calls these unknown catastrophic risks "black swans." But not all black swans are bad; some of them can result in astoundingly good fortune. More generally, Taleb defines a black swan as "a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was."

In one passage in the middle of the book, Taleb observes that knowledge of the existence and prevalence of black swans can actually help us make wiser investment decisions (boldface mine):

If you know that you are vulnerable to prediction errors, and if you accept that most "risk measures" are flawed, because of the Black Swan, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in "medium risk" investments (how do you know it is medium risk? by listening to tenure-seeking "experts"?), you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills--as safe a class of instruments as you can manage to find on this planet. The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options), preferably venture capital-style portfolios. That way you do not depend on errors of risk management; no Black Swan can hurt you at all, beyond your "floor," the nest egg that you have in maximally safe investments. Or, equivalently, you can have a speculative portfolio and insure it (if possible) against losses of more than, say, 15 percent. You are "clipping" your incomputable risk, the one that is harmful to you. Instead of having medium risk, you have high risk on one side and no risk on the other. The average will be medium risk but constitutes a positive exposure to the Black Swan.

This "barbell strategy" of being simultaneously hyperconservative and hyperaggressive embodies an example of what decision theorists and game theorists call "minimax" and "maximin" rules: (1) minimizing one's maximum possible loss and (b) maximizing one's minimum possible gain. By being hyperconservative with the majority of one's portfolio, one ensures that a massive decrease in the portfolio's value will be avoided (minimax). And by being hyperaggressive with a sliver of the portfolio, one maximizes the gains to be achieved if that sliver happens to do well (maximin). In other words, the biggest of the bad black swans can't hurt you very much, but the biggest of the good black swans can help you quite a bit. Theoretically speaking, this is a solid investing strategy for an environment in which massive uncertainty abounds.

There's just one problem with it. Notice the phrase I highlighted in boldface in the passage above: "...extremely safe instruments, like Treasury bills--as safe a class of instruments as you can manage to find on this planet." Talk about irony; Taleb's entire book is an explication of how and why most people are disturbingly unaware of black swans, yet his confident statement about the safety of Treasury bills betrays a lack of awareness of one of the biggest black swans of our time: The fate of the U.S. federal government and, by extension, anyone holding its debt instruments and using its currency.

One of the biggest financial risks in the U.S. today is default or hyperinflation by the federal government. Its ever-growing mountain of debt, combined with its ever-growing trade deficit, means that for decades, the U.S. has effectively been importing massive quantities of real goods from abroad in exchange for borrowed dollars. We have been able to get away with it thus far only because the dollar enjoys the privileged status of being the official global reserve currency. But when economic reality reasserts itself and our foreign creditors come to their senses, the dollar will be dropped--either immediately or gradually--as the global reserve currency. At that point, the U.S. government will have to choose between (a) default or (b) hyperinflation. Raising taxes by the amount required to eliminate the debt will be unrealistic and therefore not a viable option.

Whether the government chooses default or hyperinflation (my bet is on hyperinflation since it's easier for politicians), Treasury bills will become worthless. In the former case, Treasury holders will not get their principal paid back. In the latter case, they'll get their principal paid back, but only in near-worthless dollars since the money will be printed out of thin air by the Federal Reserve. Yet most people seeking preservation of capital continue to buy Treasury bills like they're the safest financial instrument in the world. Those people are in great financial danger and they don't even know it. Talk about a black swan!

Even if the U.S. default/hyperinflation scenario does not play out within the next few years, investors are still faced with the reality that Treasury bills provide a guaranteed negative real rate of return. In other words, if you invest in Treasury bills, you're guaranteed to lose purchasing power over time. The reason is inflation. If you ignore the "official" government estimate of price increases--the Consumer Price Index (CPI)--and instead look at an unbiased estimate (e.g., from Shadow Government Statistics), you see that overall prices are currently increasing around 8% per year. With Treasury bill yields currently close to zero, this means that money invested in Treasury bills currently have a real (as opposed to nominal) yield close to negative 8%. That's an 8% loss every year. That's not being "hyperconservative"; that's being fleeced.

What has happened over the years is that governments and their central banks have gradually made financial risk-taking unavoidable. "Hyperconservative" investments no longer exist. Years ago, when most developed countries in the world still backed their currencies with gold, simply saving was a safe and effective way to preserve one's wealth. Saved gold--even gold stuffed under one's mattress--would actually grow in purchasing power over time as the economy grew. (Increasing amounts of goods and services + a fixed supply of gold = increased purchasing power per unit of gold.) The discipline of gold rewarded the virtue of thrift. Those days are gone. Now, government policies punish thrift and conservative investment decisions. In order to get a positive real rate of return and defend oneself against the impending financial meltdown of the U.S. government, one is now forced to invest in assets that have historically been referred to as "risky": foreign currencies and stocks, precious metals, commodities, etc.

These days, all investing is risky business. The investors who think they're avoiding risk (including the ones who buy Treasury bills) are just unaware of how vulnerable their portfolios really are.

The Untouchables

A couple of days ago I watched the 1987 film The Untouchables for the first time. Disappointlingly, it presents a statist perspective on the issue of alcohol prohibition in the 1920s and early 1930s.

The opening scene shows Al Capone (Robert De Niro) being interviewed by a journalist as some of his servants simultaneously shave his face, file his fingernails, and shine his shoes. The journalist asks Capone facetiously what it's like to be the virtual mayor of Chicago. Capone responds:

Well, I tell you, you know, it's touching. Like a lot of things in life, we laugh because it's funny, and we laugh because it's true. Some people say, reformers here say, 'Put that man in jail, what does he think he is doing?' Well, what I hope I'm doing. . . is I'm responding to the will of the people. People are gonna drink. You know, I know, we all know that, and all I do is act on that. And all this talk of bootlegging. What is bootlegging? On the boat, it's bootlegging. On Lake Shore Drive, it's hospitality.

That short monologue is, in my opinion, one of the best scenes in the film. With wit and humor, De Niro gets right to the heart of the issue of the hypocrisy and arbitrariness of prohibition. Unfortunately, the rest of the film is spent discrediting in various ways the anti-prohibition (one might almost say libertarian) sentiment behind De Niro's opening monologue.

For example, the film's protagonist, Bureau of Prohibition agent Eliot Ness (Kevin Costner), is depicted as a veritable saint. During the press conference in which Mr. Ness announces the formation of a new partnership between the Bureau of Prohibition and the Chicago Police in order to crack down on bootleg alcohol, the following exchange takes place.

Journalist: "What do you think about prohibition, Mr. Ness?"
Mr. Ness: "I'll tell you exactly what I think about prohibition. It is the law of the land."


That exchange, although short, actually reveals everything we need to know about Mr. Ness's motives regarding prohibition throughout the rest of the film. What Mr. Ness is communicating with his short, matter-of-fact answer to the journalists is that his involvement in enforcing prohibition has nothing to do with his personal ethics--what he thinks is right and wrong, and why. It simply has to do with his unquestioned obedience to the state: "It is the law of the land." Period.

Throughout the film, Mr. Ness's saintly character is reinforced with scenes depicting him as a loving husband, caring father, protector of babies, and all-around swell guy. Meanwhile, Al Capone is depicted as a psychotic murderer whose henchmen blow people up with suitcase bombs merely for declining to purchase any of their bootleg liquor. Not exactly three-dimensional characters.

The most laughably absurd and hypocritical part of the film, though, is the last scene, which takes place as Mr. Ness exits the Chicago courthouse victorious after Al Capone has been convicted on tax-evasion charges. A journalist approaches Mr. Ness excitedly, and the following exchange takes place.

Journalist: "Mr. Ness! Mr. Ness! Any comment for the record? 'The man who put Al Capone on the spot.'"
Mr. Ness: "I just happened to be there when the wheel went round."
Journalist: "They say they're going to repeal prohibition. What will you do then?"
Mr. Ness: (With a wry grin) "I think I'll have a drink."

This, coming from the same man who declared war against bootleg alcohol? If it was not already painfully obvious to the audience that Mr. Ness's personal ethics had absolutely nothing to do with his crusade against illegal liquor, this scene removes any shadow of a doubt. The protagonist's sole motivation to support prohibition is his unfailing devotion to the state, nothing more. If the state says alcohol is illegal, Mr. Ness wages an all-out war on bootleg liquor and risks himself and his family in the process. But if the state says it's okay to drink, well then, by Golly, Mr. Ness will have a drink!

Although The Untouchables is an entertaining film showcasing excellent performances by some top-notch actors, the perspective of its story did not sit well with my libertarian nature. Rather than point out the hypocrisy and absurdity of prohibition, or at least depict some real ethical exploration of the subject, the film panders to the inherently circular statist mentality that the law is the law because... well... it's the law.

Has the Gold Rush Even Started?

Today I came across this article on Businessweek that claims we may be in the midst of a "modern day gold rush."

As evidence of this supposed gold rush, the article mentions various people that have taken up the hobby of gold prospecting, or "recreational mining," and have joined groups centered around the activity. The piece also mentions a few companies that are rolling out plans to sell gold-for-cash and cash-for-gold vending machines in locations such as upscale hotels, airports, and casinos. Yet more evidence offered in the article to support the idea of a sizzling-hot gold market is the recent business growth experienced by companies that insure physical precious metal holdings (e.g., in safe deposit boxes or home safes), as well as recently rising sales by safe makers.

Admittedly, those are all good signs that the gold market and its related businesses are indeed doing quite well. From a certain myopic perspective, I can even understand why some people would think the gold market is in the midst of a bubble. After all, everyday people taking up "recreational mining" as a hobby sounds disturbingly reminiscent of the everyday people who became day-traders during the dot-com bubble and the everyday people who became part-time or even full-time real estate agents during the housing bubble. To paraphrase Doug French, president of the Ludwig von Mises Institute, from his April 2009 lecture "Bubble Economics": A speculative bubble has officially peaked when strippers start giving investment tips.

But the fact that some people happen to be prospecting for gold in their spare time doesn't mean much by itself. The real question is how many people are prospecting for gold in their spare time. To give you some perspective, at the peak of the housing boom several years ago, close to one out of every 100 people in Las Vegas was working as a real estate agent. With that many people participating in the speculative mania, it was virtually impossible not to have at least a couple of friends or family members who were working in real estate. It was a similar story during the dot-com bubble, when just about everybody seemed to be dispensing stock tips and was planning to start their own Internet companies and make millions practically overnight by "going public." It was absolute insanity both times.

This supposed "gold rush" is nothing like that--not yet, anyways. Not even close. How do I know this? Because nobody owns gold yet. Sure, a lot of Austro-libertarians and gold bugs own some gold, and a lot of those people own quite a bit of gold, but that's a drop in the bucket. It's miniscule. To speak in terms of a speculative mania is to speak in terms of entire financial markets, entire economies, entire populations... millions of people.

The average investor does not own any gold. If you doubt this, just start taking a random sampling of the people you talk to on a day-to-day basis. Find a way to work the topic of investing into the conversation. Ask them where they buy their gold, and most of them will give you a strange look--because they don't own any. When you see the occasional TV or magazine ad relating to gold, note that they are usually informing you how to sell your gold to them (cash for gold jewelry and scrap gold, etc.). Those businesses aren't run by dummies. Their financial aim is to buy low and sell high. The reason they want you to sell your gold to them right now is because its price is cheap, and they want to buy it cheap. They know that soon the price is going to rise--and rise, and rise--and when it rises high enough, the TV and magazine ads you see will be informing you how to buy gold from the same businesses that bought it from you on the cheap. But at that point, you'll have to pay top dollar for it.

When will we know a gold bubble has actually formed and is ready to burst? I'm not exactly sure, but I suspect we'll know it when our doctors, dentists, hairdressers, and Starbucks baristas are all offering gold stock tips and starting to quit their jobs to become full-time gold prospectors. Until then, I'm going to keep buying gold and silver. It's dirt cheap.