The Permanent Portfolio and Government Bonds

I am a big proponent of the permanent portfolio as described by Harry Browne in his book Fail-Safe Investing.  I believe you should have a majority of your investments in a setup like the permanent portfolio.  For more conservative investors, it should be closer to 100% of your investments (not counting any investment real estate).

The one thing that scares many people, particularly libertarians, is the bond portion.  You are supposed to invest 25% in long-term government bonds.  Many libertarians (and others) are convinced that rates will be going up.  This would drive down the value of the bonds.  Ironically, I have heard this for many years now, even about 7 or 8 years ago when Harry Browne was alive.  Yet, bonds have done quite well over this period of time.

I understand the fear that people have of government bonds.  You shouldn’t be afraid of an outright default, as we see coming in Europe.  I’m not saying it isn’t possible, but I think we still have quite a bit of time before the U.S. government considers an outright default.  The main threat is rising interest rates.  If we hit a period of higher price inflation and the Fed is forced to stop buying government debt, then higher interest rates will probably occur.

The problem here is that the future is unpredictable.  Japan has really high debt and yet interest rates have stayed very low there for decades.  The bond portion of the permanent portfolio is designed to keep the portfolio performing well in the face of a deflation/ depression.  It actually kept the portfolio from falling too dramatically in the fall of 2008 when stocks and gold tumbled down.

So I have come up with a compromise for those interested in the permanent portfolio, yet too scared to put such a big portion in bonds.

Earlier this year, I wrote a special report titled, “Should You Pay Down Your Mortgage?“.  It is available on kindle for just 99 cents and can be read in less than an hour.  I have mixed opinions on this subject and I laid out the pros and cons of paying down or paying off your home mortgage.

One thing I mention is that paying down your mortgage is somewhat of a hedge against deflation.  While actually selling your house might be a better hedge, that isn’t a realistic option for many people.  Some people don’t want to rent.  Plus, it wouldn’t make much sense to sell your house in anticipation of deflation when you can’t be certain of the future.  If the deflation doesn’t come, then it was a bad decision to sell.

So here is my proposal, assuming you have a mortgage and assuming you have money to invest.

Instead of investing 25% in bonds, take half of that portion and make a payment towards the principal balance on your home mortgage.  In other words, let’s say that you have $20,000 to invest.  You will take $5,000 and buy gold or gold investments.  You will take $5,000 and buy a broad stock market index.  You will take $5,000 and put it in some kind of a money market fund.  For the remaining $5,000, you will take $2,500 of it and put it in long-term government bonds and you will take the other $2,500 and pay down the principal on your mortgage.

Assuming you have an interest rate of 4% on your home loan, you will get the equivalent of a 4% return on this money.  You will essentially be locking in that return with compounding interest, so it will benefit you if interest rates go lower. In other words, it is somewhat of a hedge against deflation.  If you have trouble thinking of it this way, just think that having a big mortgage is a hedge against inflation.  You can pay off your mortgage in depreciating money as time goes on.

With that said, I wouldn’t recommend taking the full 25% and paying down your mortgage.  You have more leverage with the bonds.  In addition, paying down your mortgage makes that money illiquid.  If there is a deflationary depression, you need to be able to rebalance your portfolio.  That’s why you should still leave a portion in bonds in your permanent portfolio, even if it is a smaller amount.

This is not an exact science, but neither is the permanent portfolio.  It is just a suggestion for those of you who are really scared of buying bonds with rates so low.  If you have a mortgage, then you can hedge against deflation by paying that down.