Lately, it has become fashionable again to talk about “Lazy portfolios”. Here we will use the term “Permanent Portfolios”*, as it is the best known among them (although this is a linguistic simplification).
What are “permanent portfolios”?
Permanent portfolios” are nothing more than long-term strategic asset allocations in which the assets comprising the portfolio are loosely correlated with each other, respond to different risk and return factors, and are periodically rebalanced to maintain the same risk characteristics.
Each asset tends to perform better than others under certain specific conditions. And the better performance of these compensates for assets that, on the contrary, perform worse in those particular circumstances. By choosing a well-balanced allocation with assets that perform well under different conditions, the portfolio can be prepared to withstand any situation without the need to change allocations or foresee the future (hence its “permanent” nature).
The objective is to have a portfolio with a more or less well-prepared exposure to different macroeconomic scenarios that may arise in the future.
Diversification is achieved not only by assets but also by different risk/return combinations.
“Permanent portfolios and economic scenarios
Generally, the different possible scenarios are determined by inflation and economic growth. Essentially, over time, we can find ourselves in conditions of growth above or below expectations, and inflation above or below expectations. This allows us to divide the economic context into 4 quadrants.
Once these quadrants have been defined, it is time to incorporate the four main asset classes with which these portfolios are usually constructed and see in which of the four quadrants they tend to perform best:
- Equities (variable income)
- Government bonds (fixed income)
- Commodities
- Gold
Stocks tend to excel in periods of economic growth above expectations, as this translates into increased revenues and margins.
Stocks, on the other hand, perform worse in periods of inflation, because this results in a containment of production costs, which are not fully passed on to consumers.
Government bonds tend to excel in periods of inflation and when economic growth is below expectations. In these economic conditions, bond yields compress and central banks intervene to lower official rates, driving bond prices higher.
Commodities tend to excel in periods of economic growth above expectations, as increased economic activity results in higher demand. Commodities excel in periods of inflation above expectations, precisely because their higher prices often push up the general price level.
Gold excels when inflation is above expectations, because investors buy it to preserve the real value of their portfolios. Gold also tends to excel in periods of recession, as a safe haven, and because lower interest rates reduce its opportunity cost. However, this relationship is quite unstable.
Permanent portfolios in the face of inflation and growth
So let’s map them onto the graph from before, keeping in mind that this is still a simplification, since quadrant membership is not exclusive.
Let us now begin to map a portfolio composed of several assets in the context of the four quadrants. We will assume that each asset tends to “pull” the portfolio to which it belongs towards its quadrant with a force proportional to:
- The weight of the asset within the portfolio
- Volatility of the asset
Why volatility? Because we assume that, all things being equal, a more volatile asset tends to make a portfolio more sensitive to the risk and return factors to which the asset responds. The resulting strength of the interaction of the individual forces with which individual assets pull exposure in their own quadrant will determine the overall mapping of the portfolio.
For example, take the classic 60/40 portfolio (60% stocks and 40% government bonds). In this portfolio, equity risk is predominant. The portfolio therefore performs well in prosperous conditions when economic growth is high and inflation is under control. However, the portfolio is vulnerable in periods of below-expectation growth and above-expectation inflation.
Now let’s take a portfolio composed of 20% stocks and 80% government bonds. As you can see, the resulting portfolio has shifted quadrants and tends to perform well in periods of recession, but will suffer obvious underperformance in conditions of economic growth or inflation.
Let us now imagine that we want to make the initial 60/40 portfolio less vulnerable to inflationary periods by removing 20% of stocks and adding 10% gold and 10% commodities. As can be seen, the resulting 40/40/10/10 portfolio is less exposed to periods of high inflation.
One can play freely with the distribution of the portfolios.
It is not a scientific method, of course, but it is useful for reflection.
Let us now try to map the main “permanent portfolios”. As will be seen, the characteristics in terms of risk and return of each of these portfolios are mostly the result of this initial mapping. Let’s position six portfolios on the chart:
- 20/80 (20% stocks/ 80% bonds)
- Permanent portfolio
- All seasons
- Golden butterfly (for all seasons)
- 60/40 (60% stocks/40% bonds)
- Ivy (from the most prestigious universities)*
Below you can see in more detail the distribution of these portfolios, where the main risk and return metrics for the last 30 years are also shown.
It can be generally deduced that the various “lazy portfolios” (which we have been referring to here as permanent portfolios) reflect the character of the initial design for which they were created.
The more prudent ones, which are positioned in the lower left quadrant (and the first 3 on the left in the table), perform well in times of recession and therefore have more controlled risks. However, on the other hand, they perform less well in periods of growth (lower right quadrant and on the right in the table).
On the contrary, the portfolios that perform better in phases of economic growth (lower right quadrant and on the right of the table) are those with higher annual returns, but with greater fluctuations.
* The Ivy League is a group of eight private universities in the United States that are recognized for their academic prestige, history, and influence both nationally and internationally. These institutions are known for their high educational standards, world-class research programs, and for having a very competitive admissions process.
The universities that are part of the Ivy League are:
- Harvard University (Cambridge, Massachusetts)
- Yale University (New Haven, Connecticut)
- Princeton University (Princeton, New Jersey)
- Columbia University (Nueva York, Nueva York)
- University of Pennsylvania (Philadelphia, Pennsylvania)
Permanent portfolios vs. target/horizon portfolios
In short, these portfolios are a good solution to simplify and dedicate little time to the management of our investment portfolios: we will have a solution that works reasonably well over long periods. It can also be a solution for grouping management in a single portfolio to cover different needs. We will not be perfectly positioned in each of the situations, but we will do reasonably well for all of them (over the long term). At inbestMe, the portfolios that are most similar to a permanent portfolio would be the ETF profile 5 or profile 6 portfolios, even so, they are not exactly the same. If you want a personalized portfolio, 100% aligned with a permanent one, you can access the Advanced service (from 100,000 euros) where we can customize your portfolio. If you are interested, please contact us.
At inbestMe we believe that, in general, it is best to align our portfolio(s) to our objectives or horizons and allocate to each of them to the most appropriate portfolio, especially if our needs go from one extreme to the other (initial savings/retirement):
- savings portfolios for immediate savings or emergency funds
- target or bond portfolios for short-term objectives
- indexed (diversified) portfolios for medium- or long-term objectives
- pension plan portfolios for retirement.
This can be done, even combined and effortlessly, thanks to the automation we have developed at inbestMe.
