Hard to justify Harry Browne portfolio structure

Reader portfolio: Anon

Price and value as at 14 December 2011.

Chris Dillow, Investors Chronicle's economist, says:

One thing I like about this portfolio is the core-satellite approach to your equity holdings; some tracker funds accompanied by holdings of a few specific stocks. You've avoided the common mistake of buying equities scattergun-style and so ending up with a messy and expensive closet tracker.

I also like your recognition that you can't spread risk merely by holding equities. There's a good spread of assets here: bonds, commodities and index-linked bonds, as well as shares.

Herein, though, lies a quibble. Isn't this so well diversified that you've not only minimised downside risk, but upside risk too? The Harry Browne permanent portfolio structure is intended to be a highly risk-averse one, as gold, long bonds and shares often move in opposite directions.

Put it this way. In what possible states of the world would this portfolio pay off well?

It's not a world in which the global economy does surprisingly well, because in this state your gains on shares would be offset by losses on your bond funds. Conversely, a recession would see your bonds thrive but your shares suffer. The same is true – more so – if we get another financial crisis; yes, this might benefit gold and bonds, but it would be goodnight for your bank stocks.

The only state I can imagine it doing well in is one in which central banks print money and successfully stimulate growth and inflation. Their buying of bonds would keep their prices up; the rise in inflation expectations would help your index-linked bonds, and the improved growth outlook would help shares.

This is certainly a possible (likely?) scenario. But it is not the only one. What's more, it is one that you have some exposure to via another of your assets – your labour income. Unless you are working somewhere odd, this could well rise if we do get a pick-up in growth and (long-term) inflation. Do you really therefore need the extra exposure to inflation expectations that index-linked bonds provide – especially when their expected returns are so low?

If I were looking only at this portfolio, I would guess it were owned by a retired person on level annuities looking for protection against the inflation that would erode his real living standards – not by a youngish working person.

I suspect, though, that you recognise this issue, as you say that you find it hard to justify holding a lot in long bonds and cash at record low rates.

There's a good reason and a bad one for this feeling.

The bad one is the feeling that low returns on cash and bonds somehow make other assets attractive. In themselves, they do not. Low expected returns on cash should, in theory, mean low expected returns on other assets. One reason why the gold price is so high is that it tends to rise as interest rates fall – but a high price often means low expected returns. And interest rates are low precisely because investors and central banks are worried about the economy – which is not an environment in which shares thrive.

In this sense, low interest rates are not a cue to shift into other assets. They are instead a sign that our investment opportunities are poor across the board.

Why, then, might there be a good feeling behind your sentiment? I suspect it might be because you feel that a mere 25 per cent in equities is just too cautious. It is possible that sentiment towards the world economy is now so depressed that it is more likely to change for the better than the worse. Perhaps you feel that you are insufficiently exposed to this risk. It would be this feeling – and not the mere fact of low interest rates – that would justify increasing your equity weighting, perhaps at the expense of some of those index-linked funds.

Keith Bowman, equity analyst at Hargreaves Lansdown Stockbrokers, says:

You hold a diversified portfolio of investments, with thought clearly given to asset class along with diversification within each particular asset class.

Under your investment strategy, your portfolio is allocated across four core asset classes: equities, bonds, gold and cash. In addition, and helping to provide diversification within each asset class you hold a series of exchange-traded funds (ETFs), supplemented by both more traditional managed funds and individual equities.

You highlight your discomfort in holding 25 per cent in both bonds and cash in the current low interest rate environment.

Ultimately, your dilemma is that of investors globally. In more normal times, an outlook for inflation growth, preferably moderate, sets the backdrop. However, the current backdrop is far from normal. Following a banking crisis and considerable subsequent central bank action across many parts of the world, the outlook for either price inflation or deflation (falling prices) remains highly uncertain. Central bank action, as with the Bank of England, has made holding cash highly unattractive.

Central banks, again including the Bank of England, continue to pursue policies of quantitative easing – policies involving the purchase of bonds. As such, a major buyer of bonds persists, aiding prices, reducing yields and leaving many bond investors feeling uneasy.

In all, the dilemma for investors looks likely to continue. While only the passing of time will provide the correct asset class allocation, some form of diversification across the spectrum still appears sensible – a fact appearing to provide some validation of Harry Browne's investment strategy.

As for some specifics of the portfolio, while diversification is generally gained via ETFs and managed funds, duplication in the individual equities held does raise a question mark – for example, shares in both Barclays and Lloyds are held.

The recent sale of an ETF invested in silver also provides a point of interest. The investment is likely to have proved something of a proxy for gold. A recent strengthening of the US dollar has seen gold, priced in US dollars, fall. With gold over recent years increasingly seen as a currency in its own right, the direction of the US dollar remains crucial to gold investors. Over recent months, the US economy has appeared relatively healthy when compared with others in Europe. The question for investors is will this relative economic strength continue or will it eventually fall victim to its own political gridlock, a scenario potentially proving favourable to gold investors.