That makes sense as far as it goes, but it doesn't go nearly far enough. At this time in history, the chance of the stock market advancing significantly for any period of time is close to zero, because stocks as a whole are still greatly overvalued even after the declines of the last two years.

And bonds aren't really quite as secure as that standard formula indicates. If you don't believe me, ask the holders of WorldCom bonds, who have lost almost all of their investment.

So let's take a look at another way to look at investing: as a hedge against uncertainty.

Harry Browne's Permanent Portfolio Theory

Harry Browne, a hard money advocate for many years and an author of numerous books about investments (as well as the 2000 Libertarian Party presidential candidate), invented an investment strategy called the "permanent portfolio". The general idea of this approach is that there are four basic classes of investments investors should primarily concern themselves with: stocks, Treasury bonds, cash (Treasury bills), and precious metals. He did some analysis of past trends in those markets and discovered that a portfolio consisting of equal parts of each of those four types of investments was not terribly volatile and had a relatively consistent rate of return. Of course, such a portfolio would never do as well as one that was over-weighted toward whatever investment was going to go up in the next time period, but unfortunately that information is not available when you need to know it. This approach, on the other hand, does not require precognition, but just some simple mechanical adjustments whenever one of the portfolio segments gets out of balance with the others.

How did he decide on those four classes of investments? The basic idea is that each of those investments does well under certain economic circumstances: stocks during "prosperity", Treasury bonds during "depression", Treasury bills during "tight money", and precious metals during "inflation". So whatever economic circumstances occur, your portfolio should not be too seriously affected, because whatever investments are depressed by the current circumstances, some of the other ones would counteract that. (Note: any inaccuracies in my description of his investment strategy are entirely my responsibility, not Harry's.)

However, I think he missed something in this analysis: the value of your earning ability.

Your Biggest Asset

If you are in or near retirement, your net worth is reasonably accurately represented by your investments. In that case, I agree that Harry's permanent portfolio approach makes a lot of sense.

But what if you are 10, 20, or 30 years away from retirement? In that case, it is a virtual certainty that your biggest asset is the present value of your future earnings. For example, let's assume that you have $200,000 in investments, and make $50,000 a year, with 20 years to retirement. In that case, given some reasonable financial assumptions, the present value of your earnings could be approximately $600,000, or 75% of your net worth. This means that your portfolio is seriously unbalanced, because the adverse effects of various economic circumstances can hurt your earning ability much more than your portfolio investments can compensate for.

How does this affect the proper portfolio allocation? To figure this out, let's analyze which economic circumstances will affect your earning power in which direction.

How Economic Conditions Affect Earning Power

Clearly, "prosperity" (defined as a generally rising stock market and relatively restrained inflation) is the best scenario for most people's earning power. When the economy is humming along, most people don't have much difficulty finding jobs and earning a living.

How about "inflation" (defined as a period of rapidly rising prices)? That isn't very good for most people's actual earning power. They may get raises and stay employed, but the purchasing power of their pay tends to lag behind. And, of course, it's possible to have rising inflation and rising unemployment, which is a double whammy for those who are in fact unemployed during such periods. Not only are they out of work, but their cost of living is going up rapidly.

Almost everyone knows that "depression" (defined as a period of high unemployment and low business activity, with low interest rates) is bad for earning a living.

Finally, "tight money" (defined as a period of high interest rates intended to reduce the rate of price increases) is very painful and usually coincides with high unemployment. However, this circumstance cannot continue indefinitely, as high interest rates choke off business activity and lead to one of the other conditions within a year or two. Nonetheless, it's no fun while it lasts.

What Does This Mean to Investors?

Since "prosperity" is good for both earning power and stocks, having one-quarter of your investment portfolio in stocks is much too high. When the stock market is declining, both your stocks and your earning power are being impaired simultaneously. To be properly hedged, you probably should have almost no stocks when you are far from retirement. If the general economy does well, your earning power will allow you to make and save a substantial amount of money. If the general economy does not do well, you may be laid off and see your stocks decline at the same time. This is somewhat like the problem of Enron employees who had most or all of their investments in the stock of their company. They lost their jobs and their investments at the same time.

What about Treasury bonds? They do well in a typical "depression", with declining interest rates for such bonds driving up their prices. This seems to be a good hedge against the high unemployment rate seen in depressions. However, this is far from a perfect hedge because it is entirely possible to have an inflationary depression, where the value of money is going down at the same time as unemployment is rising. In such a case, bonds would be a very poor hedge.

Treasury bills have an interest rate that keeps pace with inflation, so your purchasing power should remain relatively constant even if the inflation rate is fairly high. This doesn't allow you to make money, but at least you keep the money that you already have rather than losing it as you might with the other investments. And in a depression, where banks are often closed and bank accounts inaccessible, Treasury bills may still be accessible. If so, that would be a great advantage to their holders, as their purchasing power would likely be quite high in such a circumstance.

Finally, we have precious metals. Gold and silver bullion are not subject to loss in the case of bank failures or fraud (e.g., Enron, WorldCom, Tyco, etc.). They generally keep their value during inflation and depression, and can increase in purchasing power greatly if there's a general crisis of confidence (e.g., Argentina).

Hedging Your Earning Power

So taking this all into account, if you are not near retirement age, you might want to consider holding most of your financial assets in precious metals and treasury bills. If we have "prosperity", your earning power will enable you to live well and save for the future. In other circumstances, your portfolio will keep its value or increase, which is a great comfort when earning a living becomes difficult due to economic circumstances.

But what if you are nearing retirement age? I'll try to analyze that in a future essay.

Disclaimer

Note: I am not a financial adviser. This article represents only my own opinions on the markets and the economy.

--

Steve Heller
www.steveheller.com
Author of "Learning to Program in C++", "Who's Afraid of C++?", "Who's Afraid of More C++?", "Optimizing C++", and other books. Free online versions of "Who's Afraid of C++?" and "Optimizing C++" are now available at www.steveheller.com/whos and www.steveheller.com/opt

July 8, 2002