Ray Dalio’s All-Weather Portfolio is very similar to Harry Browne’s Permanent Portfolio. I am not sure who came up with this concept first. I guess it doesn’t matter. Bridgewater (Ray’s Fund Management company) wrote about the story of All-Weather Portfolio and it is available here. If you are lazy to read the entire article, I have extracted the important points which apply to both All-Weather and Permanent Portfolio.
The Origin of Investment Returns
“The reality is that the return of that product, or any product, is a function of a) the return on cash b) the excess return of a market (beta) above the cash rate and c) the ‘tilts’ or manager stock selection (alpha)… In summary:
return = cash + beta + alpha”
In other words, cash returns is the interest earned from bank savings account and fixed deposits. Beta returns are asset class returns. For example, long term returns of a basket of stocks, or long term returns of government bonds. STI ETF returns is considered beta returns. Alpha is where the investor value add in terms of returns above beta, through stock selection or market timing. For example, STI ETF returns is 8% and if the fund’s portfolio returns is 10%, the fund is said to be generating alpha.
Focus on Beta Returns
“Betas in aggregate and over time outperform cash. There are few ‘sure things’ in investing. That betas rise over time relative to cash is one of them. Once one strips out the return of cash and betas, alpha is a zero sum game. If you buy and I sell, only one of us can be right.The key for most investors is fixing their beta asset allocation, not trading the market well.” [emphasis mine]
Betas are indeed sure thing to outperform cash in terms of returns. The caveat is that the investor is able to stomach the volatility, overcome greed and fear, and stay invested to achieve beta returns. For example, STI ETF is sure to beat your fixed deposit returns. However, the STI ETF is not crash-proof. You can have huge paper losses when the stock market crashes. And if one sells during the lows, it is not possible to achieve the long term returns of STI ETF.
“Overconfidence often pushes people to tinker with things they do not deeply understand, leading them to over-complicate, over-engineer, and over-optimize.”
Most investors are overconfident with their ability to pick stocks and time the market. Chasing alpha is a very difficult game and most end up performing below beta returns. Doing more but achieving less. Hence, the advice is if you have no interest or the skills to beat the market, stick with index funds and be happy with beta returns.
Assets have Environmental Bias
“”Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of … growth, and cash will be the most attractive when money is tight.” Translation: all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional, equity heavy portfolio is akin to taking a huge bet on stocks and, at a more fundamental
level, that growth will be above expectations.”
Always remember there are good times and bad times for every asset class. The picture from Bridgewater says it:
Long Term Bonds to counter Risk in Stocks
“To ‘hedge’ this risk, the equities needed to be paired with another asset class that also had a positive expected return (i.e. a beta) but would rise when equities fell and do so in a roughly similar magnitude to the decline in the stocks.”
People always focus on bond yields when I talked about Permanent Portfolio. They entirely missed the concept and the role of bonds in the portfolio. As mentioned by Bridgewater, equities need an asset class that can provide an equal in magnitude price move in the opposite direction. Only long term bonds have this characteristic, whereby the rise in bond price during a stock market crash can help to cushion part, if not all, of the losses in stocks.
Inflation Hurts both Bonds and Stocks
“They also knew there were other environments that hurt both stocks and bonds, such as rising inflation.”
Stocks and bonds are not sufficient as inflationary condition would hurt both stocks and bonds. Hence, Bridgewater added the inflation-linked bonds to their portfolio, whereby the bonds returns will equal the inflation rate. Permanent Portfolio is different in this aspect. Instead of inflation-linked bonds, Permanent Portfolio adopts gold to exploit gains in an inflationary environment. I prefer gold because the volatility is higher than inflation-linked bonds, and owning gold means less exposure to government securities (All-weather Portfolio can have 50% of the portfolio tied to government bonds – 25% long term bonds + 25% inflation-linked bonds).
Prepare for Bad Weather
“The 1970’s oil shocks, the disinflation of the 1980’s or the growth disappointments post 2000 were all shifts in the environment relative to expectations.This framework captured them all. More importantly, it captured future, yet unknown surprises.”
The future is always unknown and full of surprises. An All-weather Portfolio or a Permanent Portfolio is well-constructed to help you weather through tough times while most people are not protected financially. Most investors join in parties too late. We saw how gold crashed from US$1,800 lately. It will happen to stocks, bonds, or whatever one day. Prepare for the worst and do not let greed lure you the wrong way.
“Often Bridgewater people are asked at a cocktail party or a family gathering what to invest in. They don’t delve into the active alpha portfolio. That wouldn’t be useful anyway – the portfolio moves around. What the average person needs is a good, reliable asset allocation they can hold for the long-run.”
I hate to be asked where is the market going because I do not know. It is irresponsible to tell people that they end up losing money. If you would ask me for advice, I will always begin with STI ETF and Permanent Portfolio.
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