Here are a few points on Permanent Portfolio wherein the Asset Allocation is made easy:
Are you frequently being bugged by the asset allocation decision?
Is the stock market volatility killing your portfolio returns?
Try the “Permanent Portfolio”!
It’s an alternative asset allocation concept in the financial domain. Permanent portfolio is going to give you relief from the recurring problem of asset allocation.
It relates to the manner in which you choose the asset classes initially. Then, the next level is all about allocating assets to your portfolio.
Choice of Asset Class
In the arena of portfolio management, the choice of asset class influences your returns significantly. While choosing the asset classes, you need to look into the correlation aspect.
Simply put, correlation means the direction of movement of two asset classes at a given time. To reduce the portfolio risk, you need to incorporate assets that move in the opposite direction.
Fundamentally, it means that those assets which have a negative correlation need to be chosen. It will help to check the volatility of portfolio returns. When one asset experiences a downfall, the other will rise; thereby preventing the returns erosion.
Proportion of Asset Allocation
The asset allocation decision has always been based on your risk appetite. If you are a risk-seeker, your advisor may suggest you maintain a 70:30 ratio.
It means that conventionally, an aggressive investor would prefer a typical equity portfolio. He may allocate 70% of the funds to equities and 30% of the funds to debt.
Similarly, a typical risk-averse portfolio may likely be composed of say 60% of debt and 40% of equity.
The premise behind this kind of allocation is backed by the quantum of returns expected. It was found that a higher equity allocation would result in higher portfolio returns on account of higher risk assumed.
But at the same time, it would also increase the volatility of portfolio returns. On the contrary, the return performance of debt-oriented portfolio was lower compared to an equity-dominated portfolio.
However, the volatility of returns also tends to be lower in a debt-dominated portfolio. Hence, smaller volatility always came at the cost of lower returns.
Analysts were continually trying to find a middle ground as regards asset allocation to keep the volatility at lower levels and earn expected returns consistently.
Permanent Portfolio: A middle ground
The Permanent Portfolio came as a solution to all kinds of portfolio management woes. It put an end to the recurring asset allocation and portfolio volatility problems.
While making a permanent portfolio, you need to consider two fundamentals i.e.
a. Choice of Asset Class
Instead of sticking to the traditional debt and equity, you may incorporate other asset classes as well. Try adding gold and cash to your portfolio.
All-in-all your permanent portfolio would now be composed of equity, debt, gold, and cash. A more in-depth look at these asset classes reveals that these are uncorrelated to each other.
In other words, whatever be the state of the economy, your portfolio returns would stay intact.
b. Proportion of Asset Allocation
While making a permanent portfolio, you need to give equal weight to these four asset classes.
Conventionally, you might have allocated more funds to equity or debt. But permanent portfolio calls for equal allocation to all these asset classes.
Hence, a permanent portfolio would have the following asset allocation:
– Large-cap equity fund (25%)
– Debt Fund (25%)
– Gold (25%)
– Cash/Liquid Fund (25%)
Assumptions behind permanent portfolio
Similar to other financial theories, permanent portfolio too is based on certain assumptions. These assumptions guide your rationale to decide whether or not to subscribe to a permanent portfolio.
1. The basic premise for holding a permanent portfolio is that at least one of the four asset classes will always perform well.
2. Another assumption is that the portfolio is re-balanced once a year. The investment horizon is assumed to be long-term say 10 years.
It’s because of involvement of equity component. Equity investments begin performing well only in the long term. Holding equity-only portfolios can be risky in the short-term due to high volatility.
3. At a given time, the economy might be in one of the following states, i.e., prosperity, recession, inflation or deflation.
Prosperity is a period when markets are bullish and doing exceptionally well. On the contrary, the recession is just the opposite of prosperity. During the recession, there is a general slowdown in the economy.
Inflation refers to the state of rapid increase in prices of goods and services. Deflation, also called negative inflation, is when the prices are moving southwards.
4. The assets are going to stay afloat in at least one or more states of the economy.
During prosperity, the equities perform well. Even index funds for that matter touch upper echelons of returns.
Cash component like liquid funds of the permanent portfolio is going to do well at the time of recession.
Gold is an ideal partner when the economy faces inflationary pressures.
During deflation and prosperity, Long-term bonds help to keep the portfolio returns in line with expectations.
How to use Permanent Portfolio?
The concept of the Permanent portfolio is efficient in nature. You may easily apply it in your portfolio construction.
The graph below shows the returns of permanent portfolio vs. its components beginning from the year 1999 to 2016.
The permanent portfolio is composed of stocks, government securities, gold, and treasury bill. All the asset classes have been combined in equal proportion, i.e., 25% each.
The X-axis shows the holding period starting from 1999 to 2016. The Y-axis depicts the annualized returns in percentage.
You can quickly make out that all the asset classes move in opposite direction at any given point on the graph. When you look at annualized returns of individual components, there’s high volatility.
But the light pink line which depicts permanent portfolio is relatively smooth.
The table given below shows the annual returns of the four asset classes along with the permanent portfolio (PP).
Returns of Sensex lie in the range of -52.45 (2008) to 81.03%(2009). Returns of G-Sec lie in the range of -12.16% (2009) to 28.43%(2001).
Returns of Gold lie in the range of -5.94% (2015) to 42.70%(2011). Returns of T-Bill lie in the range of 2.51% (2009) to 12.25%(1999).
However, returns of permanent portfolio lie in the range of -0.98% (2008) to 25.83%(2003). The volatility of the permanent portfolio is the lowest compared to standalone equity, debt, and gold.
Similarly, permanent portfolio yielded negative returns only once in 18 years. However, the frequency of negative returns of Sensex, G-Sec, and Gold stood at 5, 3 and 4 respectively.
When the markets started breaking down during the financial crisis of 2007-08, permanent portfolio arrested losses to end at -0.98%.
When the recovery began from 2009, permanent portfolio gave higher returns than standalone returns of G-Sec, Gold and T-bill.
Although permanent portfolio might be unable to beat the benchmark during bull runs, it’s resilient enough to check returns erosion during a downfall.
Permanent portfolio is meant for those who want lower portfolio volatility and want to escape asset allocation decisions. However, these would come at the cost of lower returns.