Gold in the Permanent Portfolio

[prestojx]

I have a question for you Permanent Portfolio experts out there.

First, let me say that I agree wholeheartedly with the basic concepts of the PP. My broad asset allocation is 1/3 Equities, 1/3 Fixed Income and 1/3 Hard assets (raw timber land, commercial real estate, and gold). The gold represents about 2% of my total portfolio.

With gold's significant drop (-29% this year - with this being the first yearly decline since 2000 and the biggest since 1981), I have been giving it more thought.

Here is my question.
The PP theory says gold should do well when inflation is high but the run up since 2002 seems to have very little to do with inflation and much more to do with the global increase in all commodity prices – steel, oil, etc. etc. based on the global (read Chinese) surge in consumption.

Inflation was essentially the same in the 2000s or even lower than it was in the 80s and 90s but gold was flat until 2002 and then more than tripled in price.

http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx

Without this unusual run up, the PP returns would look significantly worse.

What am I missing?

[Cyrano]

Over years or even a few decades, correlation between gold and inflation is weak. Gold does seem to maintain it's purchasing power over centuries, but it's volatile on timespans relevant to your lifetime. If it's useful in a buy and hold asset allocation, it's because of weak correlation to most other assets, but that is all.

[prestojx]

I agree. Gold seems to be a good hedge but a poor investment.
This appears to be a pretty significant flaw in the PP theory.

[Tyler]

With gold, inflation doesn't tell the whole story.  In the modern era of FED actions heavily manipulating interest rates, the real metric to look at is real interest rates: (nominal interest rate - inflation rate).  Gold does extremely well when there are negative real interest rates, even while the direct correlation to inflation sometimes looks weak due to interest rate moves.  It did great in the 70s with very high inflation that dwarfed the high interest rates, and great in the 00's with low inflation but low interest rates.  Still, when inflation is very high nothing beats gold in protecting your purchasing power.

To perhaps over-simplify, the PP values gold as an asset for a few reasons:

1) It performs very well in times of negative real rates (including very high inflation). 
2) It is generally uncorrelated from both stocks and bonds, reducing volatility in your overall portfolio.
3) In its physical form, it is hard asset insurance against financial and currency failures.

And FWIW, if you'd like to learn more about the Permanent Portfolio, the best web resource by far is crawlingroad.com and the accompanying forum.

[prestojx]

With gold, inflation doesn't tell the whole story.  In the modern era of FED actions heavily manipulating interest rates, the real metric to look at is real interest rates: (nominal interest rate - inflation rate).  Gold does extremely well when there are negative real interest rates, even while the direct correlation to inflation sometimes looks weak due to interest rate moves.  It did great in the 70s with very high inflation that dwarfed the high interest rates, and great in the 00's with low inflation but low interest rates.  Still, when inflation is very high nothing beats gold in protecting your purchasing power.

So do you think Gold's incredible run up from 2002 to 2013 was due primarily to negative real interest rates? Do you think it was just a coincidence that many other commodity prices jacked through the roof also and just happened to correspond to a huge consumer advance in China?

The problem is that the PP doesn't say anything about real interest rates only inflation, which as you say (and I agree) is different. I personally believe that this is a flaw in the PP theory. And that is coming from someone that has a significant amount of Gold in a safety deposit box (I am not a gold hater).

To perhaps over-simplify, the PP values gold as an asset for a few reasons:

1) It performs very well in times of negative real rates (including very high inflation). 
2) It is generally uncorrelated from both stocks and bonds, reducing volatility in your overall portfolio.
3) In its physical form, it is hard asset insurance against financial and currency failures.

And FWIW, if you'd like to learn more about the Permanent Portfolio, the best web resource by far is crawlingroad.com and the accompanying forum.

I basically agree with #1 and #2 but not #3 (try spending a Krugerand if the US currency fails).
The problem is that #1 doesn't explain the run up after 2002 and hence my question.
What would PP returns have looked like with normal Gold returns based on inflation (or even Negative Real Interest rates)?

I posted the same thing on the crawlingroad board and got similar answers. Several people have explanations but none correspond to PP theory. That is why I think a 25% gold allocation will, in the long run, be a huge drag on portfolio performance.

[Tyler]

Real interest rates were certainly negative while gold rose over the last ten years. I won't argue that other commodities are not also good portfolio assets in this situation, only that gold is a particularly good one. If your primary objection to the PP is that you don't like how the "theory" promotes the inflation protecting aspects of gold, that's fine although I think it dismisses the results a little too easily.

Gold has not historically been a drag at all - over the period since the dollar was taken off the gold standard (the situation the PP was designed for) it has matched the standard boglehead portfolio return with a fraction of the volatility. Perhaps you believe the future will be different and gold will only go down, and your guess is as good as mine. That's fine, but the most fundamental tenet of the PP theory is that one cannot predict the future.

I in no way pitch the permanent portfolio as the be-all-end-all investment that everyone should embrace. But it works very well for me, and I just try to share my own experience and knowledge. Whatever your disposition, just try to find something you can stick with in good times and bad.

[prestojx]

Real interest rates were certainly negative while gold rose over the last ten years. I won't argue that other commodities are not also good portfolio assets in this situation, only that gold is a particularly good one. If your primary objection to the PP is that you don't like how the "theory" promotes the inflation protecting aspects of gold, that's fine although I think it dismisses the results a little too easily.

Gold has not historically been a drag at all - over the period since the dollar was taken off the gold standard (the situation the PP was designed for) it has matched the standard boglehead portfolio return with a fraction of the volatility. Perhaps you believe the future will be different and gold will only go down, and your guess is as good as mine. That's fine, but the most fundamental tenet of the PP theory is that one cannot predict the future.

I in no way pitch the permanent portfolio as the be-all-end-all investment that everyone should embrace. But it works very well for me, and I just try to share my own experience and knowledge. Whatever your disposition, just try to find something you can stick with in good times and bad.

Good points amigo!
I agree that consistency is one of the few real secrets to building a successful portfolio.

Like I mentioned, my portfolio contains 1/3 real assets (land, commercial RE, and Gold). I am trying to think through whether or not to increase my Gold holdings (right now I own 400 ozs). My Raw land holdings and Commercial RE are hard assets but also have characteristics of active businesses.

I have owned my Gold for over 20 years and it has been essentially flat until 2002 and I believe the spike (2002 - 2013) is an aberration - I don't like making decisions on aberrations.

[Tyler]

I have owned my Gold for over 20 years and it has been essentially flat until 2002 and I believe the spike (2002 - 2013) is an aberration - I don't like making decisions on aberrations.

I totally agree.  However, often "aberration" is a matter of timeframe.  If you look at the last 40 years, stocks did well in the 80s and 90s but were flat in the 70's and 00's.  Gold did well in the 70's and 00's and was flat in the 80's and 90's.  Taken separately, one could argue both are fickle investments prone to long periods of minimal returns spanning a decade or more.  Combined, they make for pretty consistent growth.  ; )

Who knows what the future will hold.  Here's hoping we both do well!

[prestojx]

True and thanks for your perspective.
I think I am going to add a bit to my gold holdings and hope for the best.

Here's hoping 2014 is your best year ever!

[tomsang]

I am trying to think through whether or not to increase my Gold holdings (right now I own 400 ozs). My Raw land holdings and Commercial RE are hard assets but also have characteristics of active businesses.

I have owned my Gold for over 20 years and it has been essentially flat until 2002 and I believe the spike (2002 - 2013) is an aberration - I don't like making decisions on aberrations.

I have a question for you Permanent Portfolio experts out there.

First, let me say that I agree wholeheartedly with the basic concepts of the PP. My broad asset allocation is 1/3 Equities, 1/3 Fixed Income and 1/3 Hard assets (raw timber land, commercial real estate, and gold). The gold represents about 2% of my total portfolio.

If you can pare down your expenses and live off of like $500,000 a year you can live forever off of your $25 million portfolio. At your levels there should not be worry about your financial future.

[Mr Mark]

^^ this.

Maybe your branch out some of that 400 ounces into bitcoin! ;-)