Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 21 – A More Sensible Use of Hedges

As I mentioned in the last lesson, the Permanent Portfolio (PP) is NOT an example of a well-diversified portfolio. It does, however, have, in my opinion, three excellent hedges: Treasury bills, Treasury bonds, and gold. Hedges, as insurance, are to protect you against losses you can’t afford to take. If you’re a long-term investor, a short-term decline is a risk you can afford, in which case hedges are rationally unnecessary (emotionally is another question).

If you are drawing from your investments to live, however, you may need to protect yourself against temporary declines. The easiest way to do this, as I mentioned in an earlier lesson, is to keep two years’ worth of spending money in cash equivalents and draw from it during bear markets. But as long as you’re accepting an absence of growth prospects in some of your assets, I have no objection to substituting the three PP hedges for pure cash.

So let’s assume you want to live off your investments for the rest of your life, and either the mortality tables, a psychic, or a Mafia hit man said you were going to die exactly 30 years from today. I chose 30 years because that is the joint life expectancy of a couple retiring at 62 and also the length of time typically used in estimates of the safe withdrawal rate (SWR) from a portfolio. The 30-year SWR is the percentage of assets that can be removed in the first year and then be adjusted every subsequent year for changes in the cost of living for at least a total of 30 years before running out of money.

I looked at every overlapping 30-year period in American history for which data is currently available, beginning with 1802-1831 and ending with 1983-2012. That represents 182 different 30-year intervals. I assumed that you placed your assets in the Permanent Portfolio at the start of each period, drew a designated percentage at the end of the first year, and rebalanced the remaining portfolio back to the PP allocations (25% each in U.S. stocks, Treasury bonds, Treasury bills, and gold). In subsequent years, the withdrawal was adjusted for the inflation (or deflation) that occurred that year. I assumed there were no taxes or expenses caused by the trading done each year, which is a silly assumption, but not a big issue for my purpose, which is only to determine how changes in the allocations affected the SWR. I also think it is silly to use this kind of a system for your entire retirement. In my opinion, it makes more sense to start higher than the SWR and then be flexible based on the performance of the investments: why impoverish your retirement in advance without waiting for evidence that you need to be more frugal? Anyway, let’s just look at this hyper-conservative approach to determine which portfolio is safest compared to the others.

The SWR for the Permanent Portfolio was only 3.7%, meaning that was the highest first year withdrawal that was sustainable for 30 years in every one of those 182 overlapping 30-year intervals. Starting with $1,000,000, that would have allowed only a $37,000 withdrawal at the end of the first year if the investor wanted to be sure the funds lasted regardless of which year the withdrawals started. In case you’re wondering, the interval that came closest to bankruptcy was 1910-1939, when the hyperinflation of World War I clobbered Treasuries and later the Great Crash devastated stocks, while gold basically just held its real value throughout. From the original
$1,000,000 on January 1, 1910, only $103 would have been left on December 31, 1939.

Was this the best you could do? Not by a long shot. Had you been less focused on the short-term volatility of stocks and more focused on the long-term lousy returns of bonds, bills, and gold, you would have been a lot better off. So I started taking 1% out of each of the three hedges and adding it to stocks to see if the amount remaining in the worst 30-year interval might be better than $103. First, I tried 24% each in bonds, bills, and gold, allowing 28% in stocks, and it turned out that you would have ended your worst 30 years (the same 1910-1939 period) with $29,117 instead of $103 had you started at 3.7% draws. Not enough improvement to raise your SWR to 3.8%, but definitely an indication that you’re heading in the right direction.

I’m not going to take you through every 1% decrease in each hedge and corresponding 3% increase in stocks. Let me just note that the amount you’d have left over grew with every single increase in stocks and decrease in hedges until your WORST leftover stake after 30 years of 3.7% draws adjusted for inflation topped out at $428,678 had you maintained 85% in U.S. stocks and only 5% each in Treasury bonds, Treasury bills, and gold, which is a heck of a lot better than $103. Alternatively, you could have increased your initial withdrawal percentage from 3.7% to 4.0% and still had $52,449 left at the end of 30 years in the worst interval, which was now 1929-1958.

I should mention that the highest possible SWR occurred when stocks were at 79% and hedges at 7% each. At that level you could have started at 4.2% and lasted 30 years no matter when in American history you retired. Keeping in mind that we can’t be overly precise based just on history, it is still reasonable to conclude that a person who keeps 80-85% in stocks and only 15-20% in hedges is actually a lot safer than the follower of the Permanent Portfolio. In fact, while the SWR does drop once stocks go over 79% and the leftover cash after 3.7% withdrawals does drop once the stock percentage exceeds 85%, you can go all the way to 95% stocks and still have a safer portfolio than the PP. Moreover, if you start at 95% stocks (meaning less than 2% in each of the hedges), the likelihood is that your portfolio will grow substantially and you’ll be able to increase your withdrawals heavily over time (since you can safely raise your withdrawals more than inflation if the portfolio itself grows faster than inflation, as it is far more likely to do with a 95% stake in stocks).

The way I look at it, if people following the Permanent Portfolio feel safe, then they should feel safe with other portfolios that have less risk than the PP of going belly up during a typical retirement — which happens to include just about any portfolio that satisfies two criteria: (1) the stock portion is thoroughly diversified, both geographically and by industry, and (2) enough money is kept in hedges so that the investor could, if necessary, go two years without making any withdrawals from the stock investments by spending the hedge money. Which hedge? Almost ANY reasonable hedge — whether that means bank accounts, savings bonds, money market funds, Treasury bills, Treasury notes, Treasury bonds, TIPS, diversified bonds, gold, silver, diversified commodities, managed futures, or a little of each — will work fine. And if there are no plans to spend from the account in the next two years? Then what exactly are you hedging for?
Since this blog is intended to discuss much more than investments, I’m just going to give one more investment lesson for the time being and will finally tell you exactly which mutual fund is the very best for you to choose. Well, okay, I can’t do that because I don’t know you. But I’ll do the next best thing: I’ll tell you the name of the only mutual fund my wife and I currently own.