And here is the table:

Here are the Lazy Portfolio Smackdown results for 2011. Note: these numbers are preliminary because mutual fund dividends have not yet been reported. So those lazy portfolios that hold mutual funds that pay dividends in mid to late December will probably end up about 1% higher than these numbers.

Incredibly, the Harry Browne Permanent Portfolio wins again. It beat all other non-permanent portfolios by at least 5.5%! Have a look at the chart:

Click on the image to get a larger, more readable graphic.

To see the components of each Lazy Portfolio, visit the Professional Lazy Portfolios page.

Look how steadily the Harry Browne Permanent Portfolio (HBPP) gained during 2011. Especially when compared to the rest. Look at the wild ride they would have put you through from April until September. Tough to stomach that!

And for those of you who love a more tabular look:

Breaking down the HBPP, here are how the individual components performed for 2011:

  WOW, who would have thought that long-term treasuries would go up 34%? And look at gold, up almost 10%, which also marks its 11th consecutive year of gains. Holy bullion Batman! Even cash money did you better than your bank account, up 1.4% in short-term Treasuries.

Thank you Harry Browne!

How about the losers? Well, the silly Dilbert portfolio, all stocks, dropped almost 10%. Scott Adams recommended this (google it), but it is pretty dumb. Not much less dumb is the portfolio I put out a few years ago, also all stocks, that sought to mimic the IFA Portfolio 100, their riskiest plan. So in a year when risky stocks did poorly, portfolios that invested in all risky stocks stunk.

How about something more reasonable? Good old Rick Ferri, the guy who says his “best investment in gold was his wedding ring” how did he do for you in 2011? Here is his portfolio (prior to December dividend reporting)

He puts 40% into a broad bond index, thinks REITs are cool, and adds some international equities for spice. The portfolio gained you less than if you had put the whole thing into SHY, the short-term treasuries fund. (But dividends for December are still coming) That’s pretty stinky. And as you can see from the chart, you got a pretty wild ride in 2011 to boot. And he makes money doing this?

Which non-Permanent Portfolio did best in 2011? That would be the Scott Burns Couch Potato Portfolio, up 5.9%. (And remember that December dividends aren’t yet included in this result.)

Two funds: stocks and TIPS. Stocks flat-lined. TIPS made you some money. And the ride wasn’t too wild, especially when compared to the others. But HBPP was better in both performance and risk.

I don’t want to wrap up this year-end review without mentioning the poor performance of PFPFX, the Permanent Portfolio Fund. With HBPP up 11.5%, you’d expect that the mutual fund loosely based upon his philosophy would be close to that, but you’d be wrong. PRPFX was up only 2.2% (including December dividends) for 2011. Why? Because it deviates from HBPP in risky ways including Silver, Swiss Francs, and growth stocks. And of course it has a 0.77% expense ratio for its management fees. That is disappointing. But THEY got $118 million, based upon having $15.4 billion invested. I’m not liking this.

Gee whiz, I wish I could create a mutual fund that invested in VTI, 30-year Treasuries, IAU, and short-term Treasuries. I’d pay something like 0.08% and would charge you people 0.20%. Let’s see, with $15 billion dollars under management, I’d take in $18 million each year. Easy money!

And for your tabular view:

1-mo: -5.2%

2-mo: -8.3%

YTD: -5.2%

Since 12/31/09: 5.4%

There should only be a 3 Fund portfolio comprised of the following (and the %’s vary for individual investors):

40% Vanguard Total Stock Market Index Fund (VTSMX)
20% Vanguard Total International (VGTSX)
40% Vanguard Total Bond Market (VBMFX)

I will correct this in future portfolio analysis updates.

click for full-size ugly graphology

Let’s look at 1 and 2 month returns just for fun, ok? First, returns for September 2011:

Next, returns for August and September 2011 combined:

Ouch Rick Ferri! I think it was this time last year when I went to the Bogleheads convention and Rick Ferri laughed at the idea of owning gold. Who’s laughing now, Ricki? Difference between bottom and top is almost 22%. That’s shocking.

And of course, full Year-To-Date returns for 2011 through September:

Wow, only two Lazy Portfolios are positive this year. Guess who???

It is striking that the PRPFX mutual fund is off so significantly from the pure Harry Browne ETF version. It is probably due to the fact that PRPFX holds some silver, which got killed, and foreign currencies, which were down against the dollar. 

Harry Browne, thank you.

The individual components of the Permanent Portfolios are as follows:

VTI +2.0% – Total Stock Market

TLT -3.1% – Long Term Bonds

IAU -6.4% – Gold

SHY  +0.1% – T-bills

—-

VBR +0.6% – Small Cap Value

VWO -3.4% – Emerging Markets

And for reference, here the components of all of the Lazy Portfolios we track here.

I forgot that his comparison page only goes back to 1985 and that I was the one who modified the page to go back to 1972. Guess I’ve got some work to do.

Have fun.

The fund expense ratios (according to morningstar.com except GTU* ) are as follows:

GLD: 0.40%

IAU: 0.25%

GTU: 0.38%*

SGOL: 0.39%

DGL: .75%

UBG: 0.30%

Cumulative Monthly Performance of Select Lazy Portfolios for 2010 (Click for big view. Data from Yahoo! Finance adjusted quotes from 12/31/09 through 12/31/10 except IFA from IFA.com and after max 0.9% advisor fee.)

The IFA 100 portfolio consists of 100% stocks and is designed to be IFA’s riskiest portfolio while the PRPFX is roughly 25% stocks and is designed to be lowest risk for return. Pretty interesting that they are the two highest returning portfolios for 2010. And they reached their peaks taking wildly different paths. The IFA 100 was erratic while the PRPFX was smooth and steady. The HBPP and PBPP were even steadier but with slightly lower returns than PRPFX.

In a fairer comparison of IFA portfolios to permanent portfolios, the IFA 50 had a 13.0% gain. The long term risk of IFA 50 is closer than IFA 100 to that of HBPP.

One of the surprises of 2010 was the relatively poor performance of the Larry Swedroe Minimum Fat Tails portfolio. Its long term risk-adjusted results for the last 30 years were quite good when compared to the HBPP. But not so in 2010. Digging into it shows that 70% of the portfolio is in TIPS or short term Treasuries. They were up 6.1% and 2.3%, respectively. The other 30% of the portfolio is 15% small cap value and 15% emerging market. They helped to bring the whole portfolio up to a 8% return for the year. I have often heard people say that investing in TIPS is protection against inflation. I think I’d rather have gold (up 29.3%) serving as intended in its inflation-protection role.

The purist Harry Browne Permanent Portfolio (ETF version) which invests one quarter in each stocks, bonds, cash, and gold had these respective gains: VTI 17.4%, TLT 9.0%, SHY 2.3%, and GLD 29.3% for a total return of 14.5%.

My variation of Harry Browne’s portfolio was up 15.8% because of a slightly riskier stock position. Instead of putting a quarter in VTI (up 17.4%), I place an eighth in small cap value (VBR up 25.1%) and an eighth in emerging markets (VWO up 19.5%) for a combined stocks gain of 22.3%.

And in a final note, I am finally fully invested in my own portfolio, with some minor variations due to legacy investments (like that amazing SCCO). So with my large cash holding through most of the year, my portfolio gained 11.3% in 2010. Considering that I am counting on an average 6% gain, I dun purty good.

Good luck in 2011. See you right here again in 365 days.

[Returns computed using Yahoo! Finance adjusted historical quotes from 12/31/09 through 12/31/10 except IFA from IFA.com and after 0.9% max advisor fee.]

Click for larger graphic.

Data calculated using Yahoo! Finance historical adjusted quotes, except for IFA from IFA.com and using 11/29/10 data. There may be errors in the calculations, invest at your own risk.

Recently, I have been computing the Max Drawdown of the many Lazy Portfolios. I modified Simba’s spreadsheet to include monthly returns data instead of just yearly data because a portfolio could suffer drawdown within the year and recover before the end of the year, thus masking the fact that a larger drawdown occurred.

The following chart shows the Annualized Returns vs. Monthly Max Drawdown for several Lazy Portfolios from the beginning of 2001 through the end of 2009. (I am in the process of renumbering the Lazy Portfolios, so this post does not correlate with previous posts. See the Appendix for portfolio names.)

Figure 1: Annualized Return vs. Monthly Max Drawdown 2001 – 2009. Click it for a larger chart. See the full legend below.

This next figure is the more traditional chart showing Annualized Returns vs Annualized Standard Deviation in percent.

Figure 2: Annualized Return vs Annualized Standard Deviation 2001 – 2009. Click it for a larger chart. See the full legend below.

The ideal location of a portfolio’s plot point would be at the top left of either chart.

I was really surprised that these two charts looked so similar. Most of the Lazy Portfolios are in the same relative location on both charts. There are some small variations for select plots, but overall the chart looks the same. The biggest part of my surprise is that the Max Drawdown chart used monthly data and the Standard Deviation chart used only end of year data. Specifically, the Max Drawdown chart used 83 sample points while the Standard Deviation chart used only 9. The similarity of the charts gives me confidence that using Standard Deviation as a measure of risk is appropriate for evaluating the relative performance vs. risk of the Lazy Portfolios.

However, in terms of human understandability, I like Max Drawdown better because one can immediately apply the number to their own situation. It is simply a matter of multiplying one’s portfolio value by the Max Drawdown percentage. For example, for a peak portfolio value of $100,000 invested in the PBPP, the Max Drawdown during the period was about $15,000. That number is understandable. It also is easy to compare the Max Drawdown of PBPP to the Max Drawdown of the Rick Ferri Core Four portfolio, for example, which dropped about $45,000.

The problem with Max Drawdown is that computing it requires many more sample points to get the actual value. I had previously computed Max Drawdown using only year-end values. When I did that, the Max Drawdown of the PBPP was only 0.5% compared to about 15% for using month-end values. It turns out that the PBPP dropped about 15% in 2008 but recovered most of it before the end of the year. Even so,  Obviously we would need daily values to get the true maximum number.  Even so, a chart of Max Drawdown using only year-end values showed the same relationship between the Lazy Portfolio plot points.

Max Drawdown is an easier risk number to comprehend than standard deviation. But it is more difficult to compute. And the relationship between the portfolios’ risk remains largely the same.

Appendix

The following table lists the legend key for each plotted Lazy Portfolio along with its full name.

Here is the spreadsheet of each portfolio’s holdings. Click to make it readable. Someday I will update this web site to show the contents of each of these Lazy Portfolios in HTML format.

Data is from Yahoo! Finance historical adjusted returns. Actual data used where possible. Data prior to inception for VBR used VISVX, VWO used VEIEX, TLT used VUSTX, GLD used gold, SHY used VFISX. The data and the resulting analysis may contain errors. Invest at your own risk.

Today (Thursday, 14 October) was basically Jack Bogle Day. Sure, we heard some about how the Bogleheads got started and we even took the time to go around the meeting room and have every person in attendance tell something about themselves. In addition to Jack Bogle, also in attendance are some authors of investing books you may know: Bill Bernstein, Bill Schultheis, Rick Ferri, and the authors of the various Bogleheads books.

But immediately after the introductions, Jack showed up a little early. Don’t think me presumptuous for using his nickname, that is what he prefers. He spoke with some prepared remarks for about an hour or so and then took questions for another hour or so. We had lunch, then he and Bill Bernstein answered some more questions. He then gave each of us a copy of his new book “Don’t Count On It!” Subtitled Reflections on Investment Illusions, Capitalism, “Mutual” Funds, indexing, Entrepreneurship, idealism, and Heroes. Then we stood in line to have Jack sign his name and we spoke with all of the other authors present.

Here are some representative notes and quotes I took from Jack’s talk.

“Mutual fund companies are run for the benefit of the managers and not the benefit of investors.” Except, of course, one mutual fund company…

“Last year Fidelity managers made $2.6B and Vanguard managers made $0.” [Correction: he said Fidelity's earnings were $2.6B]

He showed a chart of how Vanguard’s average expense ratio keeps dropping. But noted that now with the size of assets under management, one basis point equals $140M. So it would be easy to say, “Let’s spend $140M on something, they’ll never know.” So Jack recommends they think in terms of dollars and not in terms of basis points.

He said, “Keeping expenses low is a simple, moronically simple, yet it is an idea that nobody thought of.”

He said that in 2010,  ETF’s share of the index market matches the index fund share. ETF share of index assets is 51.9%

On the topic of holding assets for the long term, he said, “One firm holds its assets for an average of 11 seconds. I don’t know how you feel about that, but that’s not long term investing.”

“There is no place to hide these days. Never seen anything like it. Assuming we don’t have a big disaster, which is a big assumption to me, we will see 2.5% real returns on equities in future (after inflation and expenses).”

“Gold was a terrible investment over 100 years. Rank speculations. I am almost tempted to buy gold but I won’t. 1 or 2 or even 5% to play with is OK.”

“I am a little worried about the risks that are still out there. US Financials is a mess. Pensions are bankrupt. Don’t see how they will get 8%. Wall St. Values are in tatters. America has lost ability to govern itself. I find a lot of resonance when I speak about values. I find young people are seeking something nobler. I am hoping to make a tiny difference in values. To get a financial system that works for all of you and not Wall St.”

“Rebalance? Data says don’t bother. Maybe if you need a 50/50 portfolio and it gets to 60/30 then rebalance if you need to.”

“The power of money in Washington is disgusting.”

“I think about what is going on with Emerging Market funds. They are among the largest ETFs. The Data said 33% of all EM holdings were in ETFs. Makes me worried because ETF owners are traders. Suppose something happens to Brazil and traders decide to get out. Could be a big… Still, in the long run that should not matter. If EM is held up by Mutual fund demand, when they go it could cause trouble. Vanguard should be careful when getting into these funds.”

Finally, Bill Schultheis, the author of The Coffeehouse Investor, stood up and asked a question of Jack and Bill Bernstein. It was about the disaster of 401K plans for the average citizen. How they don’t understand how to invest their own money. And would Jack and Bill recommend a more managed approach. Bill answered first and said, “The less autonomity the better. Don’t let people run their own funds. I want a big maternalistic approach.” Jack basically agreed and listed a few points about 401(k) plans: “1. You’re going to borrow money from it 2. You will take it out. 3 you don’t have to contribute to it 4. The investor has no guidance . With the average 401k being $54,000, have a great retirement.” Jack prefers the idea of a privatized personal retirement plan like former President George W. Bush initially suggested.

I asked Jack about his thoughts on the future of the US Dollar and the Federal debt and how that would affect the investor. Would we see hyperinflation? He answered that currency speculation is not something to get into. That we would want the dollar to fall relative to China. That China owns a large amount of our bonds and they may fall in value if interest rates rise. He repeated that he should probably buy some gold for insurance (against the US Dollar) but that he is just “too busy” to do it.

It has been great being here at the Bogleheads 9 reunion. Everyone is nice to talk with and with such a small gathering, we have lots of time to talk to everyone.

It looks like Harry Browne was really onto something with his recommendation of owning 25% in stocks.

(click for larger graphic)

If you cannot read this, it says that the permanent portfolios are up about 20% since January 2008 and just about everything else is still negative.

And here is the table of returns through September 2010:

Data on IFA portfolios is courtesy of ifa.com. All other portfolio returns are calculated using Yahoo! Finance historical returns and may not include dividends paid in the most recent month.

Most all of the other portfolios are stock-centric and while they may own some bonds, they are usually a mixed bond portfolio instead of purely long-term (20- to 30-year) US Treasuries. None of the other own gold.

Here are the individual component YTD results of the Paul Boyer Permanent Portfolio:

• Small Cap (VBR): -0.7%
• Emerging Market (VWO): -0.5%
• 20+ Treasury Bonds (TLT): 23.6%
• Gold (GLD): 13.8%
• Cash (SHY): 2.3%

It is amazing to note that Cash in the form of short term treasuries (SHY) outperformed all but 7 of the 25 lazy portfolios! And who would have thought that long term bonds would be up 23.6% after only 8 months? Not me. And that is why one invests in a Permanent Portfolio: No one can predict the future. So invest in all four economic possibilities: prosperity, inflation, deflation, and recession.

Have you shifted into a Permanent Portfolio yet?

Here are the returns of the individual components of the lazy portfolios:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Permanent Portfolio performance during the very volatile month of May

This May was the worst May since 1940.  The Dow and VTI (total stock market) both had losses of -7.9%.  Volatility has returned to the market!  When the market is volatile, the wisdom of investing in the Permanent Portfolio becomes apparent.  The Harry Browne Permanent Portfolio always has the same four assets: total stock market (VTI), gold (GLD), long term Treasury bonds (TLT) and short term Treasury bonds (SHY).  These assets are rebalanced each year.

Let’s see how the Permanent Portfolios performed on a weekly basis for the very volatile month of May.

Date                Stocks            Gold           Long Bonds     Short Bonds      PermPort
—               VTI               GLD                 TLT                  SHY

May   3 –   7          -7.0%               2.5%              4.1%                  0.3%                     0.0%
May 10 – 14           3.0%               1.8%             -0.7%                  0.1%                     1.0%
May 17 – 21          -4.5%              -4.3%              3.7%                 0.1%                    -1.2%
May 24 – 28           0.7%               3.2%             -2.0%                  0.0%                     0.5%

Total for May       -7.9%               3.1%              5.1%                  0.5%                     0.2%

2010 to May          -0.1%             10.8%              8.9%                  1.4%                     5.5%

The week-by-week returns show that the Permanent Portfolio is much less volatile than the VTI.  The volatility is amazingly low because the VTI and TLT (and GLD) move in opposite directions — they are negatively correlated.  The first week of May provides a good example of the negative correlation of the assets:  the VTI was down -7.0% while GLD was up 2.5%, TLT was up 4.1% and SHY was up 0.3%.  This resulted in a 0.0% change for the Permanent Portfolio.  The returns for each of the other three weeks further demonstrate the negative correlations of the assets.

The final returns for the month of May show that if you had been invested in the Permanent Portfolio you would have been ahead by 0.2% instead of being behind by -7.9% for a VTI investment.  A Permanent Portfolio investor would not think that this May was the worst May since 1940.

The last line in the table shows the year-to-date returns for each of the assets.  The advantage of the Permanent Portfolios over the VTI (total stock market) is obvious.

The main problem with the Permanent Portfolio is that it is just too boring for most investors!

Below is a Return vs. Risk Chart for these portfolios from 1985 through 2009 (Note: this chart does not include returns through the end of May 2010). The ideal portfolio would be high return at low risk and thus appear at the top left of the chart. [Chart data is computed using Simba's spreadsheet from the Bogleheads.org forum with the exception of IFA portfolios from ifa.com.]

See how there is almost an invisible boundary line from lower left to upper right? That is the “Efficient Frontier” and shows that returns are correlated with risk over the long term. It is nearly impossible to construct a portfolio that will be above that efficient frontier. So the only question you need to answer is, how much risk are you willing to accept. That is, can you tolerate the downturns in the market in the short term?

Looking at a shorter term, here is a chart showing just the previous ten years from 2000 through 2009.

I like the boost to returns the Paul Boyer Permanent Portfolio got during prosperity and it didn’t hurt too much during recession either.

And to see if you can indeed stomach a bad short term, here is a chart with just the previous three years:

How about a chart of just the recent heyday of stocks from 2003 thru 2006:

Looking at past charts is fun, but should not be the only data you use to make investment decisions. I like the Permanent Portfolio concept because it is so simple, has low fees, and covers the four economic cycles of prosperity, inflation, deflation, and recession. It has been shown to be the lowest in risk among the lazy portfolios while not sacrificing returns. They are the only portfolios to include gold.

Here are the components of each of the portfolios*:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Would you be interested in an all-weather portfolio that, despite hardly ever changing its composition, performs creditably in almost all market environments?

Hulbert characterizes the Permanent Portfolio this way:

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value.

He describes Harry Browne’s Permanent Portfolio as an antidote to volatility. He then gives some past performance of the PRPFX fund which somewhat implements Harry Browne’s concept:

This fund over the last 15 years (through Apr. 30) has produced an 8.2% annualized return, which is remarkable given that stocks, gold and bonds did not, individually, do as well: The Wilshire 5000 index gained 7.9% over the same period, the Shearson Lehman Treasury Index produced a 6.3% annualized return, and gold bullion rose at a 7.7% annualized pace.

I might suggest that while the result of the four asset classes is low correlation, that is not the way Harry Browne explained the reasoning. Instead, the portfolio is designed to have one component that does well in each of four different economic circumstances: prosperity (stocks), inflation (gold), deflation (LT Bonds), and recession (cash). Harry said that while you can expect one of the assets to go down, the one that goes up more than makes up for the loser. For example, while one asset may go down 30% or 40%, the winning asset can go up 200% or 300%, more than making up for the loss.

I think the best thing about the portfolio is this: No one can predict the future so we might as well invest in all possibilities.

Thru yesterday’s market turmoil, the components have done the following:

VTI +2.8% (Stocks)

TLT +9.2% (Bonds)

SHY +1.3% (Cash)

GLD +10.4% (Gold)

And the total portfolio, assuming 25% in each at the start of 2010 is…

+5.9%

How’s that compare with YOUR portfolio?

And here’s the book you need to read:

First, the original portfolio:

Stocks: VTSMX (Total US Stock Market)
Bonds: VUSTX (Long-term Bond)
Cash: VMPXX (Money Market)
Gold (Kitco 1972-2004, GLD 2004-2009)

yielded the following return vs. risk:

P1 (HBPP):

Compound Annual Growth Rate (CAGR): 9.1%
Standard Deviation (Risk): 8.02%
Sharpe Ratio: 0.46

Next, substitute 2-Year Short Term Treasuries (VFISX) instead of Money Market:

P2 (P1 with 2-yr T-Bills):

CAGR: 9.5%
Standard Deviation (Risk): 8.17%
Sharpe Ratio: 0.50

Alternatively, how about for the “Prosperity” component, i.e., Stocks, we substitute  half US Small-Cap Value and half Emerging Markets for the US Total Stock Market:

P3 (P1 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 10.8%
Standard Deviation (Risk): 8.57%
Sharpe Ratio: 0.64

And finally, combine P2 and P3 to have 2-yr T-Bills, US Small Cap Value, and Emerging Market:

P4 (P2 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 11.3%
Standard Deviation (Risk): 8.65%
Sharpe Ratio: 0.68

And just for comparison I ran “Solver” on Simba’s spreadsheet to find the least risky portfolio that yielded 11.3% of that time span. It came up with the following mix:

VISVX (US Small Cap Value): 13.43%
VEIEX (Emerging Market): 14.30%
PCRIX (Commodities): 5.19%
VFITX (5-Yr T-Bills): 49.31%
VFISX (2-Yr T-Bills): 7.88%
Gold: 9.88%

Which resulted in:

P5 (Solver optimized portfolio):

CAGR: 11.3%
Standard Deviation (Risk): 7.25%
Sharpe Ratio: 0.80

And here is a chart with them all plotted, CAGR vs. Standard Deviaion (Risk):

I’ve played with lots of combinations of back-tested portfolios through many different time periods and one thing is common: substituting VISVX and VEIEX for VTSMX resulted in higher returns and a higher Sharpe Ratio. And short term T-Bills for cash also added nicely.

Note that I only show the Solver optimized portfolio (P5) for reference. I believe it strays too far from the Permanent Portfolio strategy to be safe going forward.

I talked about P4 on MMM-175: The Perfect Portfolio. While I am not yet invested in it, it is the one I am targeting. I do not expect a CAGR of 11.3% for the next 37 years, but if I can get 6% I will be very happy.

To start, I selected a widely-followed portfolio of stocks and bonds. The Fund Advice Vanguard Moderate portfolio has the following composition:

(Fund Advice recently split their recommended 12% of VDMIX into 6% VDMIX and 6% VFSVX, the All-World ex-US Small Cap index.)

The Fund Advice portfolio placed 32% in fixed-income and 68% in equities. For the period 1972 through 2009, the portfolio achieved a compound annual growth rate (CAGR) of 10.95% with a standard deviation (risk) of 11.6%. This works out to a Sharpe ratio of 0.51.

Let’s now see what would have happened if instead of 100%, we placed 75% of our investment in the Fund Advice portfolio and the remaining 25% in gold. We would have achieved a CAGR of 11.09%, a risk of 10.08%, and a Sharpe ratio of 0.58. So gold did add to the returns for the period while reducing the risk. How could that be since gold itself was very risky over the period? Gold by itself returned only 8.62% while being a whopping 26.88% risky.

How about instead of investing the 25% in risky gold, we had placed the 25% in safe but similarly rewarding Treasury Money Market fund? The Vanguard VMPXX by itself for 1972 through 2009 had a CAGR of 5.66% with a risk of only 3.03%. The resulting combination with the Fund Advice portfolio shows a CAGR of 9.75%, a risk of 8.77%, and a Sharpe ratio of 0.5.

The return vs. risk of the three portfolio mixes and the individual components gold and money market (MM) are shown in the following graph.

So against our intuition, investing in risky gold actually reduced risk in the overall portfolio while adding to the returns. It even beat a comparable portfolio that invested in money markets. This is the power of Modern Portfolio Theory in action showing that while some assets zig, others zag to combine in wonderful ways.

Sources: Vanguard.com, Simba’s spreadsheet (with 2009 data added), Bogelheads.org, FundAdvice.com.

Here is the model portfolio composition which is based on the IFA Index Portfolio 25 (source). We will call this the Vanguard 25 portfolio:

I am going to use the time period from 1999 through 2009 for the analysis. Crunching the numbers in Simba’s spreadsheet (Revised with 2009 data added. More info about the spreadsheet at the Bogleheads forum.) I come up with a compound annual growth rate (CAGR) of 5.6% with a average annualized standard deviation (risk) of 7.1%. This works out to a Sharpe ratio of 0.41 for the time span.

So, what if instead of having 100% of our total investment in the Vanguard 25 portfolio we placed just 75% of our investment in it and placed the remaining 25% in gold? Running the numbers in Simba’s spreadsheet (Simba uses this source for gold’s annual return.)  I come up with a CAGR of 7.5% with a risk of 6.9% resulting in a Sharpe ratio of 0.70. Call this one Vanguard 25 w/ Gold. The following chart plots these two results. As a reference I also show on the following charts the Harry Browne Permanent Portfolio which is comprised of 25% each of Total Stock Market (VTSMX), Long Term Gov’t Bond (VUSTX), Money Market (VMPXX), and Gold.

Also shown in the chart is the same exercise but instead of placing 25% in gold we substitute a Treasury bill money market fund (VMPXX) for the 25%. The portfolio with money market fund added resulted in a CAGR of 5.0%, risk of 5.3%, and a Sharpe ratio of 0.41. Call it the Vanguard 25 w/ T-Bills. Note that the Sharpe ratio is the same as the original portfolio because in a Sharpe ratio calculation we subtract out the risk-free rate of return of money markets. So adding money markets to a portfolio does not change the ratio of return vs. risk.

The next chart adds the individual return vs. risk of gold and money market for the same time period showing the higher risk with accompanying higher return of gold for the period.

This next chart adds the individual return vs. risk of all of the other components of the Vanguard 25 portfolio for the same time period.

And for the fun of it, I computed the optimal portfolio for the time span based upon the highest Sharpe ratio and as computed by Excel Solver. This tool allows you to specify an attribute you wish to maximize while varying the percentage amounts of the various funds. In this case, we chose to maximize the Sharpe ratio and allow Excel Solver to pick which combination of which funds achieved it. The following table shows the result.

The OPTIMAL portfolio resulted in a CAGR of 5.8%, a risk of 2.6%, and the resulting Sharpe ratio of 1.12. Its addition to the first chart is shown below.

How about continuing to optimize with a high Sharpe ratio yet obtaining greater return? To do that I subtracted some short-term bonds and added some gold leaving the other two components the same. That is, gold at 35% and bonds at 57%. This resulted in a CAGR of 7.6%, risk of 7.7% and Sharpe ratio of 0.99 and can be seen in the following chart.

Therefore, to answer the original question, “Should a portfolio own gold?” it appears that for the period 1999 through 2009 the answer would have been a resounding “yes.” We find that adding gold to the portfolio resulted in higher returns with less risk.

I caution that this process is called data mining and should only serve as input into future portfolio analysis and not serve as the only decision regarding future investments. In subsequent analysis I will not limit the possibilities to just the Vanguard 25 fund set but will open it up to Vanguard funds available since 1972 and/or 1985.

Sources: Vanguard.com, Bogleheads.org, IFA.com, and http://www.finfacts.ie/Private/curency/goldmarketprice.htm

As you can see, the Harry Browne Permanent Portfolio still has the best “top-leftedness” of these select Lazy Portfolios. It had an annualized return of 8% with an annualized standard deviation of 8.8%. That results in a nicely high Sharpe ratio of 0.75, assuming a risk-free rate of return of 1.37% for all 5 years (not likely).

The HBPP’s out-performance is due to the stellar performance of gold through all of these years. I am still not convinced this is the one for all seasons. So I will be performing some analysis of this portfolio for the years that were most favorable to equities and not gold and see how the HBPP would have held up.

Remember that you’d want your portfolio to be at the top left of the chart because their you get the higher return with the lower risk.

So for the three year period from 2007 through 2009 the Harry Browne Permanent Portfolio showed the best return and the least risk of any of the featured lazy portfolios. More analysis to come…

Have a look at this table:

On day 1, XLF rose 10% so FAS rose 30%. Great, you’re in the money.

But on day 2, XLF dropped back down to its starting price of $10.00, a decline of 9.09%. The bad news is that FAS declined 3X this amount or -27.27%. This takes its share price down to $9.45 instead of the $10 that you might expect.

So whereas XLF is unchanged after 2 days, FAS is down 5.45% after those same two days.

Why? The power of daily compounding instead of cumulative compounding. The leveraged ETFs are structured in a way that they compound on daily percent changes, not cumulative price changes. The day 2 decline of FAS should only be 23.08% to take it back to its original $10.00 per share price. But because it is 3X of XLF’s daily change, instead it declines 27.27%.

Said another way, the leveraged ETFs operate on the daily percent change not on the price of the underlying index.

Definitely not a buy and hold type of ETF! Not even for one day. Traders: set tight stops!

"…they don’t even perform as expected. The index the SKF tracks is down 14% over the past three months, so you’d figure an ETF that double or triple shorts that index would offer great returns, right? Wrong. The SKF is down 28% over the same time period.

I took a quick calculation of XLF vs SKF to see if he is right. I brought weekly historical quotes from Yahoo finance into a spreadsheet, inverted the SKF’s weekly returns and divided by two and charted it. Here’s the chart, you decide if he’s right.

Fed Chairman Ben Bernanke said the same thing on February 18th:

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

He acknowledged that they are inflating. But he threw a red herring into the mix by talking about weak economic activity and low commodity prices (Heh, except gold, right Ben?) trying to infer that they are somehow the cause of inflation. No, they are the result of inflation. Next, he went into how they will correct their inflation:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. … However, the principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.

Bernanke recognized that the plane is in a nosedive and at the last minute he plans to push on the stick and go airborne again. I hope it is not a cloudy day when he has to judge how far the plane is from the ground. He wrapped up his thoughts on inflation and how to avoid it:

As we consider new programs or the expansion of old ones, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster maximum employment and price stability.

What do *you* think the chances are that the Fed will get all of the necessary actions right? Have they gotten the necessary actions right up to this point? Let us examine a scenario where they are not able to get it right and we do indeed experience undesirable inflation, which I will define to be anything above 5% annually.

How might the various asset classes be affected in times of inflation? To answer this question, I utilized Simba ‘s spreadsheet for back-testing portfolios (which I imported into Google Spreadsheets) to do a correlation between CPI (Consumer Price Index, the government’s official inflation number) and various stock fund, bond fund, and gold returns. The data in the spreadsheet uses annual returns of Vanguard index funds along with the yearly closing price of gold from the years 1971 – 2008.  The spreadsheet already calculated the cross-correlation between each of the mutual funds and it lists the annual CPI index. So it was very easy to drop the CPI into one of the mutual fund slots and instantly see the correlation between every asset class and inflation. Here are the results, sorted by correlation:

The table shows those asset classes that were most closely correlated with the CPI at the top. Note in the third column that a value of 1 would mean the asset is perfectly correlated, -1 would mean perfectly correlated inversely (it went down exactly as CPI went up), and 0 means there was no correlation: it was random.

So we see that those assets that were most highly correlated with CPI were T-bills, gold, long-term government bonds (inversely), short-term Treasuries, and commodities.  Everything else was below 0.25 correlation. Interestingly, micro cap stocks were totally uncorrelated with inflation.

So how did a portfolio of those assets perform during the years 1973-1981 in which CPI was 8.7, 12.3, 6.9, 4.9, 6.7, 9, 13.3, 12.5, and 8.9%?

I constructed a portfolio along the lines of the Harry Browne Permanent Portfolio (HBPP invests 25% each into total US stock market, long-term bonds, money market, and gold) but I added some small cap value, micro cap, and eliminated the long-term bond fund. I then back-tested that portfolio during those inflation years. Here is the portfolio what I came up with:

The Inflation Portfolio:

VISVX (Small Cap Value) 15%
BRSIX (Micro Cap) 15%
PCRIX (Commodities) 10%
VMPXX (Money Market) 45%
Gold 15%

The "Inflation Portfolio" had a CAGR (Compound Annual Growth Rate) of 15.5% and a risk (as measured by standard deviation) of 10.5%. Plotting that on a chart, here’s what it looks like compared with some other portfolios and the assets themselves:

The chart shows plots for various portfolios during those inflation years. The plot point directly above HBPP simply substituted BRSIX for VTSMX in the HBPP. The major components of the Inflation Portfolio are also plotted separately showing how volatile gold and BRSIX were themselves. When tempered together with VMPXX, the risk came down considerably while retaining significant returns. You can see all of the rest of the details in the Google spreadsheet that I created for this scenario and you can test out other hypotheses yourself.

The Inflation Portfolio worked from 1973 through 1981. If we see inflation return, would it work again? Some folks are discussing these findings at the Bogleheads forum if you want to chime in.

Please note this is not a recommendation to invest your net worth in the Inflation Portfolio!

That posting is in error (that I do not believe was my fault). I have corrected it. It turns out that Feb 1, 2008 thru Jan 31, 2009 was not the worst 12-month rolling period, but it did come close.

I’ll be watching to see what happens at the end of this month.

Here is the corrected chart.

I have copied Simba’s Backtest Portfolio spreadsheet from the Bogleheads forum into a Google Spreadsheet that you can use to back test a portfolio of Vanguard mutual funds and compare their performance from 1972 – 2008 to the IFA Index Portfolios. Combine the funds any way you like and compare them against IFA’s twenty portfolios. I included the "returns" for gold there for your convenience.

This graph from that spreadsheet shows the plots of a few others including the Coffeehouse portfolio, Harry Browne’s Permanent Portfolio, Scott Burns’ Four Square portfolio, and a couple of others along with IFA’s portfolios (they follow a nice line). Unfortunately, Google spreadsheets doesn’t do labeling very well on the data points. I would have liked each point to be colored and have a legend identifying those colors. Anyway, remember you want to be at a point at the top left on this graph. The line that is formed is called "The Efficient Frontier" beyond which it is difficult if not impossible to achieve. The strong correlation between returns and risk is evident.  However, it is easy to be bottom right!

If you want to play with the spreadsheet yourself, feel free to bring it up. You’ll need a Google account. Leave the years to be 1972 – 2008 in order for the comparisons to be valid. Here’s the link:

https://spreadsheets.google.com/ccc?key=pOjc3ot10vgs0eml-DJZKcw&newcopy

But wait, there’s more!

IFA is now allowing you to submit your past financial statements to them so that they can compare you’re portfolio’s performance against their index portfolios. Go their web site at ifa.com to learn more. Here are some comparisons they have already performed.

The web site is http://www.icarra.com

Get over there and create an account and try it out. They have really made some nice improvements since I last used it.

FOR BEST RESULTS, AFTER YOU CLICK PLAY, CLICK THE ARROW BUTTON IN THE BOTTOM RIGHT THEN SELECT "HQ" TO GET EVERY OUNCE OF INDEXING JOY FROM THESE VIDEOS!!!

Steps 1-3

Steps 4-6

Steps 7-9

Steps 10-12

This was a lot of fun to put together. I used Keynote and then exported the show to iMovie to render the video. Images and diagrams are from ifa.com. For backtested performance information go to ifabt.com.

At the end of October 2008 we experienced the worst 12-month rolling period for stocks in 50 years. Then at the end of November we outdid that.  Now at the end of January 2009 we have a new low for a 12-month rolling period in many indexes and portfolios. We came close to the worst rolling 12 months again, but did not pass it.

The following table is taken from ifa.com, combining the returns for 11 months from 1 Feb 08 through 31 Dec 08 and the 1 month return for Jan 09.

Here is the corrected table.

Previous table, wrong:

Source: http://www.ifa.com/portfolios/PortReturnCalc/index.aspx and http://www.ifa.com/portfolios/

Then look at this…

Returns in the stock market are randomly distributed over time.

First, can you imagine the immediate shock the the economy? Could anyone really process all of these changes at once, including all of the second-order effects and how they would impact your particular situation? Shocking if done instantaneously. Even shocking if done over the span of one year. But big deal. Get over it. We can be shocked and still survive, right?

Yeah, if the USA were a closed system I think we would be just fine. We would trade our gold for the farmer’s corn. Farmers would trade gold for tractors. Tractor builders would trade gold for houses. On and on. We would employ all the former government workers as road builders. New banks would arise in cities eager to lend us some gold for capital projects. We would do just fine here in the USA.

It is the fact that the USA is not a closed system that complicates the issue. See, in this process we trade dollars for gold. Each dollar is worth 1/900 oz of gold (let’s say). Bring in your pieces of paper, your Federal Reserve Notes, to the bank and they will give you gold coins or a receipt for 100%-reserve gold coin storage.

So now we all have gold in our pockets. And we want to buy a giant LCD TV. With what exactly and from where? Dollars? Ha, they’re gone now. A TV made in the USA? Yeah, right. You gotta give up some gold to some other country. So we load up our Wal-Marts, our Dollar Trees, and our shopping malls with stuff that we trade away our gold for. That represents an outflow of gold from USA. To keep the system in balance, don’t we need a corresponding inflow of gold? Otherwise someday we completely run out of gold, right? Can’t just print more gold can we?

It is the same scenario with any government that is left over. How are they going to pay out Social Security in gold? How are they going to send thousands of troops overseas and build billion-dollar airplanes and pay people to read newspapers in fancy offices? Since they don’t have a gold mine to readily tap into, they either have to take away your gold, or have to borrow gold from China, or they have to stop spending gold. The first option quickly reaches either a point of diminishing returns or reaches a point of torches and pitchforks. The third option is their option of last resort. Which leaves us with the USA borrowing gold from China. Which is kind of making my head spin trying to think of how we are going to come up with the gold to not only pay that back but also to pay the interest.

But maybe that is the point. We would have to figure out some way of getting gold from other countries. We would have to actually make or do things that they want. For example, we could trade our tractors and our corn for their gold. We could build houses for them. We could even help build their roads. Either that or we build our own LCD TVs and stock our Wal-Marts and Dollar Trees ourselves. Shocking isn’t it? Economics does work.

As I ponder this scenario, I realize just how fortunate and prosperous we in the USA have been these past few decades. Being able to "manufacture gold out of thin air," that is, print dollars to trade to foreigners. We are so lucky that they want our fiat dollars. Because that guy reading the newspaper really isn’t a very good road builder.

He goes on to say that buy and hold is not the right approach. And I think the reason might have to do with the notion of "Austrian Investing," though he does not use those words.  Here is what he does say about buy and hold:

The problem with that approach was and is government. Government alters currency values, and this alters the value of different kinds of investments. Government creates booms and busts, and that alters investment values. The presence of government forces us to speculate.

Then he goes on to talk about how we need to find value and buy it, be it stocks, real estate, or even timber.

I am on the hunt for more information about Austrian Investing. They’ve been right about the economy, maybe they would be right about investing too.

Oh, and BTW: Mish does a pretty good destruction of Peter Schiff’s approach to Austrian Investing. Good read.

]]> http://MadMoneyMachine.com/2009/01/26/austrian-investing-continued/feed/ 0 http://MadMoneyMachine.com/2009/01/25/have-we-really-lost-wealth/ http://MadMoneyMachine.com/2009/01/25/have-we-really-lost-wealth/#comments Mon, 26 Jan 2009 04:20:56 +0000 Paul Douglas Boyer http://MadMoneyMachine.com/?p=1354 With the stock market down some 40% last year, many people are asking, "Where did the money go?" Sure there are some stock market losers. But remember the winners, those who sold their stocks in October 2007? They got their money. Remember also that for every share of stock sold, there was a share of that stock bought. But Fannie Mae used to trade for $80 a share and is now just pennies a share. Is the money just totally gone? Where did that market capitalization go? Furthermore, we need to push deeper, past the issues of money and valuations and ask, "Have we really lost wealth?" The answer may surprise. We will get to that last question in a moment. But first, let’s follow the money.

Where did the money go?

The USA Today ran a story that read, "$2 trillion wiped out of retirement funds " so far in 2008. Really? Two trillion dollars is wiped out? Lost? This is a fascinating notion. You wake up one day and wealth is suddenly gone. Vanished. Like some ice cube that has melted on a hot street. Here one moment and gone the next. As we shall see, the ice cube metaphor may be even better than it first appears. Stocks have melted.

The NPR Planet Money podcast a few weeks ago sought to answer the question "What is money?" and recently asked "Where did the money go?" To help us visualize the "loss" of money, they acted out a little skit with three market participants. At the start of the skit it was noted that among them the sum total of money was $400. Russ had $200, Alex had $200, and Lois had a house. (It was a little green Monopoly game piece house.) Russ Roberts (of EconTalk fame) decided he wanted a house. So he offered Lois $200 for hers and she accepted. Russ has the house, Lois has $200. Some time passed and then Russ wanted to sell his house. Alex was the only one who made an offer and it was for $100. Russ took the offer but was obviously unhappy about "losing" $100. At the end of the skit, Alex owned the house and $100, Lois had $200, and Russ had $100. The sum total of money was $400. Therefore, the net amount of money remained unchanged although some of the market participants had varying emotions about their transactions.

Lois was happy to receive the $200 for her house because she said she had originally purchased the house for $100. But she said that she still had to live somewhere and would now have to go and buy another house. Russ was obviously unhappy because he has $100 less than when he started. And still no house. Alex was probably the happiest because he has a nice house and still has $100 of his original $200 remaining. But with the net amount of money remaining the same, they didn’t really ask the question, "Why did the house only get an offer of $100?"  Why not a $300 offer? Don’t house prices continuously rise and never fall?  It was a fun exercise to walk through, but it still left me unsatisfied. What’s behind the rise and fall of prices? Let’s try to figure that out. But instead of houses, let’s switch over and talk about gold for a moment.

Gold and the Market

Gold is different than houses. We can’t live in gold. Instead, gold is money. Ancient money. Gold would still be money today if the governments would stop prohibiting it from being money. Consider these characteristics of money: money must be marketable, easily transportable, relatively scarce, relatively imperishable, easy to store, easily divisible, and uniform in quality. Gold meets all of these characteristics and has been used as money by default through the ages. Ironically the dollar, the world’s reserve currency, doesn’t meet all of these characteristics. It misses the scarcity test.

So let’s trade two things: dollars and gold. It used to be that a dollar represented a fixed amount of gold, but today we can trade one for the other at different amounts. If you have dollars and I have a one ounce gold coin, you can make me an offer to trade some of your dollars for my coin. I can accept or refuse. If you offer me $200, I will refuse. If you offer me $2000 I will accept. Somewhere in between these two ranges we may reach an agreement (or we may not). The more people there are around to offer bids and ask for bids, the greater the chance that someone can reach an agreement on a fair trade. As an example, say your bid for my gold coin is $600 but Troy bids $800. You may consider increasing your bid to $850 in light of his bid. But before you do, Bill next to me accepts Troy’s $800 bid for his coin. You witness that and decide to limit your bid to me to $800 also. Why pay more, right? Or if you are really trying to game me, you may hold your bid at $600 thinking that no one else is around now that will bid something higher.

This is the workings of the market. Bidding and asking is how we reach agreed-upon prices. This is why stock prices are what they are: dynamic. It is a continuous mixture of people wanting to sell at the highest asking price and people wanting to buy at the lowest bid price. But they know they are competing with other sellers and buyers for those same shares.

Motivated Sellers

Competition is the heart of the market. It is the heart of the gold market and the heart of the real estate market and the heart of the stock market and even the heart of the currency market.

In the NPR skit, Alex was able to buy the house from Russ for only $100 because there were no other offers higher and Russ really wanted to sell. A motivated seller they say. Perhaps he needed to move because of a job relocation. There are motivated sellers in all markets just as there are motivated buyers. Are there more motivated sellers than motivated buyers? Prices will fall as bids dry up. Prices will fall as the number of offers rise and the amount asked for sinks. Are there more motivated buyers? Prices will rise as bidders compete. Prices will rise as owners hold tight.

Presently in our global stock markets our global real estate markets and our global commodity markets we have not just a boatload of motivated sellers but a whole fleet of cruise ships full of motivated sellers. We have banks, brokers, hedge funds rushing for the exits at the same time, needing to sell just to get the dollars to pay off debts and client redemptions. We even have investors motivated to sell simply because they see so many other motivated sellers selling.

As naturally happens when motivated sellers outnumber motivated buyers, prices drop. We might call this an asking war , the opposite of a bidding war. Sellers lowering their asking prices in the face of other low asking prices. Asking prices for stocks go lower. Asking prices for houses go lower. Asking prices for copper goes lower. But motivation in a particular market is only part of the story. We need to also consider motivation across markets. I may want to sell my house not because of physical reasons but because of economic reasons. Perhaps I want to trade house wealth for stock wealth. I may prefer at present to rent and hold 10,000 shares of an index fund rather than owning a house. I probably will not find the exact trade I’m looking for; that is, someone to offer to trade me their 10,000 shares for my house. Instead, I’ll have to trade through money. I sell the house for dollars and then sell the dollars for the index funds.

But the net amount of money in the system doesn’t change as a result of motivations. The buyer gets to keep the net amount that the seller loses out on. Alex has the $100 instead of Russ. When prices kept going up, did anyone ask, "Where did that money come from?" Not likely. We don’t care how we got it. Yet we darn sure want to know how we lost it. But both answers are the same. The net amount of money remains constant among the total pool of buyers and sellers.

[Note that I am for purposes of this discussion ignoring the effect of fractional reserve banking and the creation of money when lent and the destruction of money when a loan is paid back. This effect is indeed serious and makes an enormous impact to the economy as a whole.]

Lost Wealth?

Now we know where the money went. It is still there. Not a satisfying answer to owners of stock mutual funds in their 401K plans who say, "Oh great, more motivated sellers means any bids I seek for my shares will be lower if I were to try to sell today." Penny’s 401K plan may have a cost basis of $100,000. And last year when she checked the bids on her portfolio it may have fetched nearly $300,000. But based upon recent offers, it may only receive bids for $150,000. That seems like lost wealth to Penny. Is it?

It depends. It might not be lost wealth to Penny. We need to look at what Penny would have wished to trade her shares of stock for? A house? If so, Penny is in luck because houses she liked that used to fetch $300,000 bids are now asking only $150,000. So Penny’s 401K plan would buy the same amount of house even though its dollar value has fallen in half. Similarly, Penny may have wished to use her 401K to travel or to eat or to pay her gas bill. Dollar values for each of these things may have fallen, but their values may have stayed relatively close to the value of her stocks over that time.

We are living in a world where bids for practically every asset are lower in comparison to bids for dollars. Many motivated sellers of stuff, many motivated buyers of dollars.

So the problem is the thing we are using as money, which itself is becoming more "valuable." The banks, brokerages, and hedge funds that need to get dollars are not just motivated sellers of stocks and commodities, but they are also motivated buyers of dollars. There are lots of motivated dollar buyers. Prices of dollars rise. Everything else seems more expensive compared to dollars as a result.

But we the investing public with 401K plans are typically not motivated buyers of dollars. We are more typically motivated buyers of the things that dollars buy. Food, travel, cars, shelter, heat, etc. When we trade one of these for the other, we might expect roughly the same item-for-item transaction this year as we did last year. The thing in the middle is what has changed: the money. The demand for the dollar by banks, brokers, and hedge funds has skewed the monetary valuations of both the things that we need to sell and the things that we want to buy. But in the end, it might possibly be that our wealth remains somewhat unchanged just like the amount of money remains unchanged among buyers and sellers.

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http://www.nytimes.com/interactive/2009/01/06/business/20090106-comeback-graphic.html

What’s neat is that if you put in a negative inflation rate, say -3%, you can get your money back in a few years even at 0% Annual return!

My comment upon his article is that it needs to be fleshed out more. Simply saying that one would follow this approach because the future is uncertain leaves a lot of arguments untouched. For instance, the article does not show how one would implement it, how it would have performed in the past, and what mathematical basis it has upon reality. Show me how such a strategy would have performed over the last 10 years. 20 years. Rolling periods. What amount of one’s investment would be eaten by fees and bid/ask spreads on these options? Can an individual actually implement such a plan or must one be a hedge fund with millions rolling around?

Wouldn’t investing in capitalism be closer to the Austrian ideal rather than speculating in financial derivatives? And particularly investing in ALL of capitalism and taking out the “controlling” decisions of some fund manager to select which companies may do better than others. This means investing in index funds. This means buying baskets of as many companies as possible, with some rational due diligence hopefully embedded in the process. By this I mean, if a company comes out and says, “We intend to close our business in the next couple of years” then by all means the index manager could have leeway to pull out of that stock.

Perhaps an important aspect of Austrian Investing was something else Terrell mentioned, 

To further explore Austrian investing, one might look at the nature of Austrian Business Cycle Theory: how can the role of the Federal Reserve in setting interest rates, causing shortages and surpluses in the market for loanable funds, the nature of malinvestment, and the inevitable boom and bust that follow, be formulated into a successful investment process?

That’s definitely something to take into consideration. Peter Schiff, Nouriel Roubini, Ron Paul, James Grant, Jim Rogers and many, many others are trying to do this too. Still, applying it to investing is akin to licking one’s finger and sticking it up to the wind. I need something more scientific, more measurable, more definitive so that I can take the belief factor out of the equation and instead invest rationally. In fact, maybe rationality is the real key to Austrian Investing after all.

For Fannie Mae (FNM) you’d need a gain of 7839%. It closed at 39.98 on 31 Dec and now trades at about 0.51.

The good folks at Index Funds Advisors have studied statistics about the stock market going back many years. One of my favorite statistics is the Monthly Rolling Period Analysis of, for example, IFA Index portfolio 100. (You can click on any of the other numbered portfolios from that page to get their Monthly Rolling Period Analysis.)  When you examine that table, you will see on the 4th row down is the 12-month rolling returns. Starting in January 1958 until December 2007 there were 589 such 12-month periods. Note we’re not just going from January to January but also February to February and March to March and so on. 

In columns six and seven you see that the worst 12-month period for the index portfolio 100 was from 10/73 until 9/74 when the portfolio experienced a loss at -35.73%. It now appears that the chart will have a new entry for lowest rolling period. According to information I have pieced together from the Benchmark Your Portfolio Tool and the Year To Date Returns of IFA Portfolios and Indexes as of Market Close 10/31/08, both available at IFA.com, the period from 11/07 thru 10/08 has just experienced a loss at -42.53% [corrected]. To arrive at this number, combine the -8% loss from 11/07 thru 12/07 with the -37.53% loss YTD in 2008. [This was the source of my math mistake: I added the percentages together.  Instead, I should take the percentage of the percentage. For example: $1000 with 8% loss is $920. $920 with 37.53% loss is $574.72. From the original $1000, that is a 42.53% loss.]

This will have a significant impact on the statistics and on the assumptions of risk going forward as the Monthly Rolling Period Analysis table gave an impression that the worst loss one might reasonably expect in a 12 month period was -35%. When the table is updated to show a maximum expected loss of 45%, it might cause investors to choose a portfolio with lower risk. Note that I have singled out 12-month rolling period. I suspect we have also set records in many other rolling periods as well. A quick check of the 2 year shows it was -23.86% and is now -29.57%. [The 2-year return is annualized, not total.] A more detailed check of the 2 year shows it was -23.86% but the most recent was only a -17.86% loss annualized.

Also using IFA data, I calculate that the S&P 500 12 month return just ended was (-4.81%) and  (-32.71%) resulting in -35.95%. If you examine the tables carefully, you will see that the S&P 500 has slightly more risk (measured by monthly standard deviation) than a portfolio 85, but with lower annualized returns. 

To create the Rolling 12-Month Analysis for any of the other 19 IFA Index Portfolios, use the Benchmark Your Portfolio Tool and select the portfolio of interest and choose the range from 1 November 2007 through 31 December 2007. Add Combine [properly] the total return (which is probably negative) to one of of the following 2008 Year-to-date returns through 31 October 2008:

But just to be fair, we should also examine the Highest Rolling Period Return and ask if we might someday overstretch its limits. It currently sits at 66.72% for the period 4/03 thru 3/04, a time after a recent recession. I wonder if after this recession we will bounce back higher? Note I’m not predicting that it will happen, just kinda wishing. Maybe after the 10% gain of the past few days, we’re on the right track?