Preparing for the Unpredicatble with a Personal Portfolio

An excerpt from the just-published book

Over the next 10 years, one investment will do better than all the others; no mix or combination of investments will be able to beat it. Unfortunately, none of us knows for sure what the big winner will be. Each of us may make a guess—and, because there are so many of us, some of the guesses will be right. But that won't mean that anyone knew the future—only that a few people estimated shrewdly or guessed well.

Uncertainty is a fact of life. The world is too complicated for anyone to be able to project all the details of the present into the future and predict where the world will be 10 years from now. But that shouldn't make you feel helpless—only humble. With a little understanding and with a good deal of financial diversification, you can prepare for the unknown. Understanding the economic principles that are at work will shield you from expectations that are based only on hope and habit—including some expectations that are widely held.

And financial diversification can protect you from what can't be foreseen. A diversified portfolio should reflect your expectations by emphasizing the investments you believe will do best. But it should also include what appear to be second- and third-best investments, as well as small amounts of hedges that probably will lose money if your favorites pay off. It isn't easy to put money into hedges you don't expect to do well, but there are two reasons that you should.

First, the future may not match your expectations. If it surprises you, the hedges will save you from a disastrous loss.

Second, even if the world 10 years from now is about as you expect, the road from here to there won't be a straight line. Your favorite investment will have ups and downs along the way—and each time it's down, you may wonder if it will ever get up again. The hedge investments provide comfort and security during those times by partially offsetting the temporary losses on your favorites.

The surprise factory in Washington will continue to be the main source of investment uncertainty—as the government looks for new ways to stitch over old problems. You can't anticipate what the government will do next year or even next month—although some actions will be less surprising than others. And even if you knew what the government would do, you still couldn't be certain of the investment effects or of their timing.

If you have opinions about the future, you should act on them. But it's a mistake to confuse opinions with knowledge. Our purpose here is to design a portfolio that emphasizes your expectations while arming you against surprises.

TWO PORTFOLIOS We think it's valuable for most investors to have two portfolios—what we call a Permanent Portfolio and a Variable Portfolio.

The Permanent Portfolio relies on balance and a long-term perspective. It contains investments that should do well in differing circumstances; thus it should have some winners no matter what happens.

Since it's designed for a long time frame—perhaps 5 to 15 years—the investments won't change. They're chosen to fit your broad expectations for the next decade or more, without regard for the ups and downs that will occur along the way—but with respect for the possibility that your long-term expectations may be mistaken.

Once a Permanent Portfolio is established, it calls for little further attention. New money may flow into it from your business or salary income, or money may flow out of it for you to live on. And, as investment prices change, small purchases and sales will be made every year or so to reestablish the percentage breakdown that you originally decided on. But such transactions are mechanical; they aren't prompted by your opinion of short-term investment trends.

The Variable Portfolio is an investment budget devoted to a shorter time frame. It might be used to buy gold if gold appears to be entering one of its periodic two-to-four-year bull markets. Or you might have various budgets within the Variable Portfolio for short-term speculations in a variety of markets that interest you.

The Variable Portfolio's purpose is to take advantage of what you believe to be the current trends in the markets. And any investment made from it will be sold as soon as the trends seem to have changed—which may be tomorrow or three years from now.

The distinction between the two portfolios is important. For example, you might hold some gold as a fixture in the Permanent Portfolio. And during times you expect the gold price to rise, you might have gold in the Variable Portfolio as well. When the temporary uptrend seemed to have ended, you would sell the gold from the Variable Portfolio. But you wouldn't sell the gold from the Permanent Portfolio, because it remains there to protect you against surprises that might send the gold price soaring.

The Permanent Portfolio is your financial fortress—designed to protect you from all the uncertainty and surprises of the next decade. If your expectations for the decade prove to be generally correct, the purchasing power of the Permanent Portfolio will increase, but it probably won't create a new fortune for you.

The Variable Portfolio is your opportunity to profit from shifting trends. If you manage it well, it might make you rich. But if your trading decisions are wrong, it will lose money—and you'll be glad you have the Permanent Portfolio to back you up.

DIVISION BETWEEN TWO PORTFOLIOS The division of funds between the two portfolios depends solely on how well you believe you can manage the Variable Portfolio. For some people, the Permanent Portfolio should have all of their assets and the Variable Portfolio none—because their investors have no interest in making short-term investment decisions. Others might have three-quarters in the Permanent Portfolio—or one-third or one-eighth. It depends on your attitude toward risk and on the confidence you have in your ability to succeed where others often fail.

The division is up to you. The only breakdown we believe makes no sense at all is to have everything in the Variable Portfolio and nothing in the Permanent Portfolio. We think everyone needs a Permanent Portfolio of some size as a backstop against a run of bad short-term investments.

One benefit of having two portfolios is that it clearly limits the money available for short-term trading. There will be only so much you can lose if the markets go against you. If the Variable Portfolio does lose money, it should be replenished only with new funds that become available—not by transferring money from the Permanent Portfolio.

When you have the Permanent Portfolio to back you up, you can afford to act more decisively with the Variable Portfolio, knowing that you aren't risking everything you have. This may improve your trading decisions by freeing you from any sense of desperation.

So you must first decide how much of your assets, if any, to risk in the Variable Portfolio. The rest of your net worth is the Permanent Portfolio, and that's what we're concerned with here.

INVESTMENT INCOME As we choose the investments that belong in the Permanent Portfolio, there will be no reference to investment income. It's as though income didn't matter—and it doesn't when making investment decisions.

It is common for someone who's retired to choose investments that will earn enough interest and dividends to cover living expenses. We think the effort in doing so is wasted and may lead to the wrong investments.

Your first consideration should be the safety of the capital that's precious to you. If the capital is lost, your income will be zero.

The second consideration should be the total return—income plus the growth of capital. The form the total return takes, whether mostly income or mostly capital appreciation, doesn't matter—except as it affects your tax bill. And your tax bill almost certainly will be lower if the return is in the form of capital appreciation.

It isn't the traditional advice, but we believe you should choose your investments without regard to the need to cover living expenses. You can provide the necessary income with a mechanical arrangement after you decide which investments make the most sense.

Suppose, for example, that you have $100,000 and you need $10,000 per year (before payment of income taxes) to live on. The traditional approach is to invest the $100,000 so that it earns $10,000 in interest and dividends. But the only requirement is that $10,000 be available to you; it doesn't need to come from interest and dividends.

Suppose that instead of basing your plans on income, you invest the $100,000 in investments that pay no interest or dividends at all but that appreciate over the long term at an average rate of 10 percent per year. You can cover your living expenses just by selling some of the investments each year. In any year, the investments may appreciate by more or less than 10 percent. All that's needed is that they appreciate by an average of at least 10 percent per year.

"Living off capital" may sound like living beyond your means, but it needn't be so. If you don't sell assets for living expenses faster than your portfolio is appreciating, your capital won't shrink—and it may even grow. What you can afford to spend without diminishing your capital is its total return—income plus appreciation—not the amount that comes to you marked "interest" or "dividends."

In fact, it may be imprudent and extravagant to treat interest and dividends as spending money. If, for example, you have your entire portfolio in Treasury bills, your income may be 10 percent per year. But if you spend it all, you're really dipping into capital. Even though the face value of the T-bill holdings is steady, the purchasing power is declining from year to year.

A further benefit of "living off capital" is that the money withdrawn from your portfolio is taxed at capital-gain rates rather than at unearned-income rates. And even if you withdraw an amount equal to all the portfolio's appreciation for the year, part of the proceeds of what you sell will be a tax-free return of capital. If half the proceeds are investment profit, for example, the effective tax rate on what you spend can't be more than 14 percent—because the maximum capital-gain rate is 28 percent.

Of course, you must choose the investments carefully. But you'd have to do that even if you restricted yourself to income-paying investments—and you'd have less of a selection from which to find the right investments.

MODEL PORTFOLIOS One of the stock features of investment books is the model portfolio—a program recommended for everyone of a given age, wealth, income, marital status, or other description, as though the advice were coming from the Census Bureau. We doubt that belonging to one of these stock categories signifies anything about what to do with your money.

A bad investment is bad—no matter who owns it. If utility stocks are a bad investment, for example, they don't become a good one in the hands of a retired person who believes he needs the dividends. And the models can be dangerous; doing what's recommended for the "middle-aged businessman"—just because you are one—may give you a false sense of security.

In many important ways, you have nothing in common with anyone else in the world. The considerations that should dictate your investment choices are unique to you; they shouldn't be overruled by an author's discovery that you belong to a certain demographic herd. Among the things to consider, four in particular should be stressed.

1. Expectations: You have expectations about the future; at the least, you have general opinions about the course of inflation and the economy. And there are certain dangers that concern you more than others. You won't be comfortable with your investment portfolio if it doesn't reflect these expectations and concerns.

2. Risk: Only you know what chances you're willing to take. What you can afford to lose without changing the way you live will depend on your net wealth, your income, and how much you need to live on. These things are measurable. But there's no way to measure the grief you'd feel from a loss or how painful it would be for you even to worry about the possibility of a loss. And only you know how strongly you feel you need to increase your wealth.

3. Tax situation: If a tax shelter for interest income (such as a pension plan, closely held corporation, or foreign trust) is available to you, you can afford to hold enough dollars to be properly prepared for a deflation. If no such shelter is available to you, however, deflation protection will be costly; you might decide to skimp on dollar holdings and take your chances, or you might choose to pay a higher tax bill as the price for greater security.

4. Personal effort: You won't be comfortable with your investment plan if it demands more of your time and attention studying the economy and the markets than you're willing to give. You may enjoy watching investments and betting on your opinions—or you may find the subject and the risk a burden. An investment plan may be brilliant, but it won't be profitable if you won't devote the attention needed to make it work.

These considerations are subjective. They involve feelings that can't be reduced to numbers and that prevent anyone but you from saying reliably the kind of investor you are. Model portfolios are for Monopoly money.

CREATING THE IDEAL PORTFOLIO It would be presumptuous for us to say we know how you should invest your money. We don't know anything about you.

We've found that it requires a minimum of two hours of conversation with a client just to get a picture of his attitude and circumstances. We can't make suggestions until we've asked enough questions to understand the client's objectives, attitude toward risk, expectations for the economy, tax problems, and many other factors. And very often, the answers to early questions are amended as the discussion digs deeper.

Obviously, we can't do that here, but there's much that we can do. Any consultation with a client is a joint effort; we make suggestions and call attention to realities, but the client always makes the final decision—just as you must make the final decision.

And the final decision is always based on one essential test. Before designing an investments program, you need to know the characteristics of the various investments on the menu and how to buy each investment; you need to crystallize your attitude toward risk and your opinions about the future; and you have to consider the tax consequences of any changes you make. But when these considerations have been integrated into a first draft of a portfolio, the essential test must be applied. And that test is simply: How comfortable do you feel about the plan?

If an investment in the portfolio makes you uneasy, maybe it should be reduced in size or replaced by another that serves the same purpose. If you feel you're not taking advantage of an opportunity you see, perhaps the budget for certain investments should be increased. The portfolio must be adjusted until you feel right about it—until you feel that it provides the combination of safety and opportunity you want.

You don't have to be a financial expert to do this. Expertise might allow you to orient your portfolio more toward profit and less toward safety, but you don't need expertise to determine whether you're comfortable with a given portfolio. Even if you have no idea what the markets will do in the coming years, you can arrange your portfolio to cover all the possibilities—thus assuring that you won't lose much of what you have now.

YOUR PORTFOLIO We can begin now to create the portfolio. To start with, we're not interested in what you own. For now, you need only to determine roughly how much you're worth. If you sold all your present investments for cash today, approximately how many dollars would you have? Only a rough figure is necessary. $5,000? $40,000? $200,000? $1,000,000? $50,000,000? Without spending more than a couple of minutes, calculate your approximate net worth (your assets minus your liabilities).

The next step is to imagine that you've sold all your present investments, and the proceeds are now sitting in dollars in a bank—waiting to be invested. Determine how much you want to allot to the Variable Portfolio. How much, if anything, are you willing to risk on your judgment of short-term trends? Whatever it is, set aside a budget for it (with no concern now for particular investments), and subtract that amount from your net worth. The remaining money is for the Permanent Portfolio.

You have a pile of dollars available for the Permanent Portfolio. How will you invest it? With the money in cash, nothing can stop you from achieving the combination of safety and opportunity you want. You don't have to wait for any investments to recoup their losses; there are no unrealized capital gains to discourage you from selling something; you have no investments on which you've staked your reputation or self-esteem; you have nothing to consider except how best to invest a pile of cash.

What would you buy? Gold, silver, stocks, foreign currencies, oil leases, commodities, real estate, T-bills, bonds, annuities, second mortgages, debentures, convertible bonds, rare art, fried-oyster franchises? What would you buy? You have the whole world to choose from.

Make a list of the investments you'd purchase with that imaginary pile of cash. And next to each investment, write the percentage of your Permanent Portfolio you want it to have.

In making these choices, what you already own isn't important. How much income you need from your portfolio isn't a consideration. What friends, relatives, and investment advisors are buying isn't important. You're making a fresh start, and the direction you take is up to you alone. There is only one consideration: If you had the money in cash right now, with no constraints on your investment choices, what combination of investments would make you feel most comfortable?

In no more than five minutes, you'll have the first sketch of your new portfolio. Then you might make some changes. When no more changes seem possible, put the sheet of paper aside. Take another look at it tomorrow. You'll probably make one or two more changes. And perhaps again the next day. After a few days, no more changes will seem possible or necessary. You'll have the ideal portfolio.

The next step is to make a list of what you own now and its present value. Then sell the amount by which any item exceeds the percentage budget you gave it in the new portfolio. With the proceeds of these sales, buy what's necessary to have enough of each item you listed in the ideal portfolio.

Of course, the transition from what you have now to what you want may not be simple. You may have investments that can't be sold easily, and you may be reluctant to pay capital-gain taxes on investments you no longer need. Many investors will end up with a compromise. But you won't get close to your ideal unless you begin by defining it—without worrying about the hurdles.

It may seem that our approach is too simple; your present assets may be spread over a multitude of investments and among a number of pockets. If there seem to be too many complications to handle, it's only because you're concentrating on where you are now, not on where you want to be.

That's why you must start with the imaginary pile of cash. Only then will you be able to look past the results of the piecemeal decisions you may have made over many years.

You do have a fresh start; you can make it any time you want by saying, "Sell." Your portfolio can be as simple or as complicated as you want it to be—but the choice shouldn't be dictated by what you happen to have now.

Once you have some figures on paper, ideas for changes will come to you faster and faster. You'll remember things that are important to you, and some of the investments that once seemed necessary may no longer be so attractive. Change the figures again—and again—until you've found the arrangement you can live with, until the portfolio appears to have been modeled on your view of the future and with your concern for safety and opportunity. Eventually, you'll have the ideal portfolio.

It isn't difficult to create the right portfolio for yourself. But it won't be the right portfolio unless you make the choices. No investment advisor nor anyone else (even if he's sure he knows what's best) will share your losses with you. You have to make the decisions because you will live with the consequences.

Harry Browne is the author of numerous bestselling financial books. Terry Coxon is a financial advisor. This article is excerpted from their recently published book, Inflation-Proofing Your Investments, by permission of the authors and publisher.

Excerpted from the book Inflation-Proofing Your Investments, published by William Morrow and Company, Inc. Copyright © 1981 by Harry Browne and Terry Coxon.