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viernes, 10 de junio de 2016

Investment Strategies: Permanent portfolio

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Investment Strategies - Permanent portfolio

In the last months of 2015 there has been a marked deterioration in the S&P 500, the benchmark of the US stock market, a situation that persists in the beginning of 2016. Among the reasons for this decline, as well as for the high volatility experienced from the summer of 2015, can be mentioned, among others, doubts about the Chinese economy, the drop in commodities (especially in oil), the political and economic uncertainty in many countries (including United States) and the South American stagnation.

In this situation, many investors watch how their portfolios are dwindling significantly, even in cases where they have diversified by sectors or by countries. If the evolution of the stock markets is analized for the long-term, it can be concluded that large oscillations occur cyclically and boom periods can be alternated with significant decreases. Therefore, some seasoned investors like Warren Buffett, advocate for the long term, as markets are efficient only when we consider a sufficiently large time period.

What is the permanent portfolio?

It is a technique devised by the financial advisor Harry Browne in the 1970s that allows us to develop a simple, balanced and diversified investment portfolio. Its main objective was to create a safe and profitable investment method with more stability over time. To do this, Browne studied the evolution of different financial assets, noting that these assets behave differently depending on the state of the economy as a whole. 

Following this theory, if the investor diversify properly in each of these groups of assets, the investment portfolio will be protected against the vagaries of the economy, as losses that may suffer in any of them will be offset by the gains obtained in other/s.

Browne described four phases in the economy, and from there identified four assets, each of which behaved well in at least one of the phases. These stages are:
  • Prosperity: GDP grows, new businesses open, unemployment is reduced, the financial system is working properly ... In this period the asset that best works are stocks, whose value increases greater than the rate economy.
  • Inflation: during inflationary periods prices rise more than the economy, and the cash loses value. At this stage, gold is the star, so that its value grows, becoming a safe haven.
  • Deflation: this would be the opposite situation to that of inflation, in which prices fall steadily, which can lead to a depressed state of the economy if the situation extends too much in the time. This is because consumers and investors will buy less (waiting for prices to fall further). Interest rates are reduced and bond prices rise, which favors investment in this asset class. 
  • Recession: During a period of recession (like the one we live in recent years), the credit is reduced and thus the amount of money in circulation. The difficulties for selling increase and many assets can not find buyers and see how their price plummets. In this situation, having cash can be more productive, because we can buy goods at a very low cost. 
 The investment portfolio composed by Harry Browne consists of only four assets:
  1. Stocks
  2. Gold 
  3. Bonds 
  4. Money

The shares will do well in times of prosperity, gold work best when inflation is high, bonds give higher profits when there is deflation and money will protect us during inflationary stages.

Harry Browne estimated that the ideal is to spread the portfolio among all these assets equitably. From there, he made a series of analyzes and simulations of how a portfolio of this type would have behaved in previous years, calculating an average return of 5% after discounting inflation, with few periods of decline. Since 1972 its profitability has been even higher, at around 10% annually, a figure similar to the return offered by equities, but with much less variability, which means that in the years you lose, you lose less.

How this system works in practice?

  • Investments are distributed evenly among the four asset classes, ie 25% in each class.
  • The portfolio is manteined at long term, with few changes, to minimize fees. 
  • The changes made are to rebalance the portfolio, that is, to adjust the weight of each asset at a percentage of 25%, since, due to variations in the asset prices, their percentages are changing (for example, if shares are rising and gold falling, the percentage of the first will be higher, while the percentage of the second will be lower).
With these premises we can meet the four requirements of an investment system:
  • Certainty: investment protection (at least to some extent) whatever the economic scenario. 
  • Profitability: it allows to get a return on investment. 
  • Stability: the investment is at long term and variability is moderate. 
  • Simplicity: It is easy to build and maintain by any investor.

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