How profitable is a bullet-proof portfolio?

A balanced portfolio with allocations to cash, bonds, gold and equities may have to contend with a lower return

 02 Mar 2013 09:55
 BY TEH HOOI LING SENIOR CORRESPONDENT

IN my column in The Sunday Times last week, I wrote about the "bullet-proof portfolio" proposed by US investment analyst and politician Harry Browne in his book, Fail-Safe Investing: Lifelong Financial Security in 30 Minutes. The so-called bullet-proof portfolio allocates equal proportions to stocks, bonds, cash and gold every year. The author reckons this type of portfolio gives the assurance "that you are financially safe, no matter what the future brings", including economic prosperity, inflation, recession or deflation.

This, the book says, is because some portion of the portfolio will perform favourably during each of those economic cycles. The book calls this type of investment portfolio a "permanent portfolio" and advocates that it be re-balanced once a year so that the 25 per cent allocation is precisely maintained for each asset class.

According to Mr Browne, a permanent portfolio should be safe, simple and stable. Last week, I tested out the performance of this kind of portfolio using data from Singapore. I downloaded the year-end numbers for the Straits Times Index, the price for gold, the price for a 15-year Singapore government bond, and one-year interbank rates. The gold price is converted to Singapore dollars. The starting year was 2003. I started with $1 million in December 2003. I allocated a quarter of the amount - $250,000 - to each of the four asset classes - Singapore blue-chip stocks, gold, Singapore 15-year government bonds, and cash. For stocks, I assumed a dividend yield of 3 per cent, except for 2008 when a yield of 4 per cent was used. The government bonds in 2003 had a coupon of 3.75 per cent, while cash earned one-year interbank rates. By the end of the first year, I trimmed the asset class that had outperformed and redeployed the funds to those which had underperformed so that we would start the second year again with a 25 per cent allocation to each of the four asset classes.

Such a strategy, without accounting for transaction costs, returned 8.2 per cent a year. The initial $1 million grew to $2.04 million by the end of last year. I received a few queries from readers regarding the column. One asked if we could substitute gold with real estate. Another enquired whether insurance could be considered an asset class. My response to the first question was that the purpose of diversification is to hold asset classes that have low - or better still, negative - correlation with one another. If equities are down, you want the other asset classes to be unaffected, or better still, to rise in value. Gold has performed that function in 2008 and beyond. Real estate, however, tends to move in tandem with the stock market.

That said, the advantage of real estate is that it has rental yield. Gold doesn't generate any income at all. Instead, there is a carrying cost for bullion. To answer the second question, insurance doesn't qualify as an asset class. As for policies that come with savings plans, the insurance companies channel your money - after hefty fees - to bonds and equities as well. In general, one should be better off just by buying the protection, and investing the rest separately. Yet another reader asked me to test out two alternative strategies to the balanced four-asset-class portfolio.

Alternative Strategy A: Start with $250,000 in each of the four asset classes, and do nothing until end-December 2012.

"As there are cyclical variations, maybe there will not be much difference between Browne's and Strategy A, and then there will be savings to be made by avoiding the conversion fees amongst the asset classes every year (which are not accounted for in your graphs). But if the final value in A is much lower, then we have demonstrated that Browne's strategy is superior," said the reader.

Alternative Strategy B: If I start with $1 million in December 2003 and allocate a third each to the three asset classes - bonds, gold and equities, what will the final portfolio value be at December 2012? Please do for two sub-cases: (a) Follow Browne's strategy, (b) Do nothing until December 2013. "Since cash is never good wealth with time, maybe it is best to leave it off the portfolio altogether! For emergency uses, cash can always be converted from gold and equities. But your calculations will be telling, either way," he wrote.

So I tested the other three strategies he suggested. Here's what I found. A buy-and-hold strategy that started with four asset classes would end 2012 at $1.95 million. That's $92,000 less than the rebalanced portfolio, or half a percentage point lower in compounded annual return.

As for the three-asset-class strategy, a buy-and-hold strategy grew $1 million to $2.2 million for a return of 9.2 per cent a year. Note that for this do-nothing strategy, cash will still accumulate over time from dividends and coupons from the government bonds. A yearly rebalanced three-asset portfolio will grow $1 million to $2.35 million, or an annual compounded return of 10 per cent a year. In this strategy, cash generated each year was redeployed into the three asset classes.

So what can we observe from the numbers? One, cash drag - the cost of holding cash - is $312,000. A rebalanced three-asset portfolio is higher than a rebalanced four-asset portfolio that includes a 25 per cent cash portion by that amount after nine years, with the starting point set at 2003. Two, for both the three and four-asset portfolios, rebalancing adds to the performance. The former by 0.7 percentage point a year over nine years, and the latter by 0.5 percentage point. I reckon the increased performance more than offsets the transaction costs.

Looking ahead, can the permanent portfolio still provide an 8 per cent return a year? I have some doubts about this. One, Singapore government bonds yields are at historic low levels - the yield for the 30-year Singapore government bond is about 2.7 per cent. In addition to the low yield, there is a risk of the bond prices falling. Two, gold prices leapt 187 per cent in Singapore-dollar terms in the last nine years. It would be hard to imagine that bullion could repeat that performance.

I believe that only equities have the potential to deliver an 8 per cent return a year. A balanced portfolio - with allocations to cash, bonds and gold and equities - may have to contend with a lower return, at least in the next five years or so.