Financial Sense   Home  l  Broadcast  l  WrapUp  l  Storm Watch  l  About Us  l  Contact Us

Building a Portfolio for Long Term Success
Including Homework Assignment #1
by Robert B. Gordon, Sc. D.
March 3, 2004

PREFACE

Old time readers will not find much new in this essay, but I hope it will clarify my previous writings and make my suggestions more usable for a greater number of readers. I am going to go over the basic principles of stable and volatile asset classes and how we assemble them into the best possible portfolio to meet a variety of requirements.

I am going to define "long term" as a maximum of 20 years, which is as far out as I can see. Hopefully any new investor, starting from scratch, will quickly acquire the ability to make on-course changes from unanticipated events.

We shall continue to place quality and safety at the top of our criteria for selecting stocks or mutual funds. The future of the economy and stock markets can only be approximated. There will never be any guarantees of success so this means each asset class must be selected from the longest possible record of past performance and especially in the four years of the current bear market.

In the sections below, we shall first review the basic story on careful asset allocation and then present a series of suggested portfolios from the simplest to the complex. We hope that a considerable number of readers will choose to start small and then add new or duplicate asset classes as their market experience grows.

Although I will continue to respond to your email questions, it will be very helpful if you make them quite specific and number them so I do not miss any in my response.

THE FUTURE IS VERY UNKNOWN

Any reader, older than twenty, who does not recognize the truth in this section heading should not be considering a portfolio of either mutual funds, stocks or bonds. The great uncertainties in the world’s economies and financial markets have never, in my opinion, been as great as they are right now. Unfortunately, ninety nine percent of the people in this country, including most of our leaders in Washington and Wall Street, do not share my pessimistic opinion. They, along with nearly all investors, are now as bullish or more so, than they were at the market top 4 years ago.

This is clearly a time to exercise caution in all of your financial affairs. In the discussion that follows, we hope that many readers will elect to start with a portfolio made up solely of stable assets classes, with no upper limit on their number. Some of those new or old investors will decide, after a year or two of experience, that they wish to add the volatile classes. That is a very good plan that should lead to success.

So far, our 4 year old bear market has been very orderly, with no single huge drop as occurred in 1930 and again in 1987. We have had in the last 15 months a very long bear market rally that turned many inexperienced investors bullish. It recently led to a record amount of growth fund purchases in the month of January. Most of this money will disappear in the next bear leg down, with or without a sharp panic crash. Our young bear market is showing none of the characteristics of the 1929 Crash which was all over in about 4 years. The reason is that the 2000 top is from a higher level Elliott Wave pattern than the earlier crash. The present U. S. bear market is very similar so far to Japan’s 14 year old bear market and depression which is showing no end in sight.

EVERYONE IS VERY BULLISH

The cash reserves available to pay refunds when an investor wants his or her money back are now hovering about 4% of total mutual fund assets. This is about as low as it ever gets and means that the funds are not worrying about safety (as they eventually will) but are fully invested to compete in the performance race with other similar funds. History shows that this number will rise to a much higher figure, possibly to 15% at the next major market low since it was at 11 to 12% at the last three market lows.

I certainly do not enjoy my lonely bearish position as I see huge numbers of investors adding to their growth stocks and funds. These unfortunate people are due to suffer large losses due to their lack of knowledge of market history and as a result of adopting poor advice from advisors, brokers and mutual fund advertising.

This is just about the last opportunity to help your family and friends escape severe losses in the next market downturn. It is a well known fact that a large percentage of unskilled investors simply do not have the will power to reach a sell decision on losing investments. So they watch their losses multiply in the dim hope of recapturing their losses. The best way to handle this problem is to urge everyone to set a definite level at which they will sell and at least recover some part of their investment.

OUR SEARCH FOR STABLE FUNDS

Strange as it may be, Morningstar, with perhaps the largest mutual fund database, does not have a fund category called "stable." The reason is very clear. For many years the entire mutual fund industry has been enamored in using growth or value and the company size as the important distinction between funds. This places a false emphasis on what the funds own and disregards the results of their investment actions. It is a sad commentary on the fund industry and its emphasis on what they buy instead of how well they do with their clients' money.

What is our definition of a stable asset? It comes from looking at long term price charts and selecting those that come closest to having an upward sloping straight line with a minimum of temporary price declines. We place great importance on the performance over the last four bear market years and like to see it go back as far as possible. Our model is the chart of the Permanent Portfolio fund which, on our FastTrack computer screen, shows a quite smooth, gently rising price line back to the start of our database in 1988.

Most of the stable funds we have identified to date hold from 60 to 100% bonds. We have set as a minimum standard that the fund must have either a 4 or 5-star rating from Morningstar which does not rank funds with less than 3 years of price history. We have made one exception in the case of the Hussman Total Return fund because of its very fine management style and straight line performance to date. We are confident that it will receive the same 5-star rating as its sister fund, the Hussman Strategic Growth fund, now holds when it is 3 years old.

The nearest approach that Morningstar ratings of 8,000 funds provide in our search is a group of funds in their "conservative allocation" category. Screening all 8,000 funds for no-load funds with 4 or 5-star performance in the conservative allocation category reduced the number to only 39 funds. This small group does includes the Permanent Portfolio fund with a fine record of more than 3 decades. It also includes several very well managed bond funds with a 4 and 5-star rating. It is a good place to start a search for buy candidates, but unfortunately an investor has to look beyond this group to create a strong balanced portfolio.

DIVERSIFICATION IS VERY IMPORTANT

There is a significant age and experience difference between me and my readers and in the fact that I was fully involved in the 1972-74 bear market. It was very scary at the time, but now compared to the 1929 and 2000 events, it looks like a picnic in the park. Some mutual funds went down 75% and there were net redemptions from mutual funds for nine years after the bull market resumed. Compare that with the record purchases of funds in January, four years after the market top. This one, big difference between 1974 and 2004 tells me that this current bear market has not really started. And, when it finally does hit, it is going to shock everyone in our country beyond belief.

I have recently written about a stable portfolio containing ten funds, several of which were essentially duplicates due to my difficulty in finding 10 unique funds. [see archive] Then, my next paper from FSO will describe 15 funds, with 2/3 of the money in stable assets and 1/3 in volatile assets. I expect to get letters questioning my sanity. Why so many funds? I cannot give any reason except that it’s better to have one too many than not enough. I expect big changes that cannot be specified in advance. Many funds, even good ones, will probably disappear.

At the start of a new portfolio, the only performance record is the past history. If you start with two or three more funds than needed, getting rid of the poorer performer is no big deal. It’s sort of like carrying an extra spare tire on a long road trip.

DEVELOPMENT OF AN UNIQUE PORTFOLIO CONCEPT

I started my writing career on the Web several years ago with the goal of helping investors, at all experience levels, do a better job of planning and managing their investments in an anticipated difficult market environment. In the first year, the market went down quite sharply in the NASDAQ with smaller drops in the S&P500 and DOW. Our essays described important asset classes like precious metals, short funds and foreign government bond funds and gave performance data on groups of mutual funds in each category. These earlier essays are archived at www.freebuck.com and can be accessed by clicking on my name listed under the Commentaries heading.

More recently, my writing has been directed at developing complete portfolios to survive a difficult bear market environment. We discussed a group of conservative asset classes to which we gave the name "stable" and another group of assets exhibiting considerable volatility with the prospect of showing overall price gains in the anticipated bear market, a group of "volatile" assets to be used in moderate amounts with other more stable assets.

In agreement with our webmaster, we developed the practice of giving the name of the stock or fund symbol of any security that was known to be unique - the only one of its type. The obvious reason was to give information to our readers that would otherwise be very difficult to obtain. A secondary reason was to make the readers dig out the identity of the other securities from a general description. And the most important reason was to give each individual reader a sense of ownership of the specific portfolio so that he or she would assume the responsibility of making future on-course changes if and when needed.

So, during the past year, I have been busy perfecting the stable/volatile portfolio concept by the process of putting real portfolios together and following their progress in the marketplace. This personal research effort is being disclosed to readers for the first time because I want them to know that a considerable part of my time and assets are involved in real-world testing.

CURRENT LIST OF STABLE ASSETS

We will first list those funds believed to be the only ones of their kind. We urge all readers to go to the fund web pages and read the literature of all listed funds. All 3 funds have a large amount of interesting information available on line.

PRPFX - The Permanent Portfolio fund which owns and maintains a fixed group of assets such as U. S. and Swiss bonds, 30% stocks, gold and silver bullion. This fund is over 30 years old and is currently doing very well in the bear market to date with a 4-star ranking.

HSTRX - The Hussman Total Return fund prospectus allows purchase of US. and foreign bonds, dividend paying stocks, gold and the use of up to a 30% hedge against any market loss. Its eighteen month performance record shows a steady 9% annual rate of return.

HSGFX - The Hussman Strategic Growth fund can employ a 100% hedge against loss and use 150% leverage to increase gains. It’s more than three year record shows about an 18% per year gain. Morningstar gives it five well deserved stars for its fine performance.

Nearly all the funds that qualify as stable assets hold from 60% to 100% bonds of high quality. One small highly special group of funds specialize in merger arbitrage. Their market performance depends on the successful conclusion of the proposed merger or acquisition. I am currently aware of 3 funds that follow this unusual strategy, but prefer the oldest fund which has earned 4 stars at Morningstar. It is one of the 39 stable funds along with PRPFX. Check it out in the manner given below and let me know if you have trouble finding it.

U.S. Treasury Securities
1. Build a 5 year "ladder" of U.S. Treasury notes maturing in 1, 2, 3, 4, and 5 years. Replace the maturing one-year note with a new 5-year note and keep the ladder going.
2. Buy a U.S. Treasury money market fund.
3. Buy a short or intermediate-term U.S. Treasury bond fund.
4. Buy a fund holding U. S. Treasury Inflation Protected bonds.
5. Buy a zero coupon U. S. Treasury bond fund maturing in 2005, 2010 or 2015.

Foreign Government Bond Funds
1. Go to a fund screener like www.bloomberg.com and search for names and symbols of Global or International Bonds.
2. Go to www.morningstar.com for fund details and its current star performance rating.

Stable Income Funds
There are several very old and stable funds holding 60-70% bonds and the balance stocks that have 5 stars and are in the Morningstar category of Conservative Allocation funds. Check them out. Do a Google search for "5 star bond funds" with no front or back sales charge.

HOMEWORK ASSIGNMENT NUMBER ONE

If you have a serious desire to be your own advisor and manage your assets, here are some suggestions on how to get started.

1. Go to www.morningstar.com, click on Tools at the top of the first page, then on the main page click on the link to the fund screener.

2. Click on All funds, then on Conservative Allocation, then click on No Load funds and finally select both 4 and 5 star funds. You should end up with an alphabetic list of 39 funds.

3. Clicking on the name of any fund will take you to the Morningstar page for that fund.

4. Note items like the fund size, the length of service of the manager(s) and all the comments from Morningstar about the particular fund.

5. Copy the fund symbols for any funds that appear of interest.

6. Go to www.bigcharts.com and enter the stock symbols to obtain a price chart compared to the Permanent Portfolio PRPFX.

7. If you succeed in carrying out the above actions, please accept my congratulations. If you had any trouble, please let me know so I can help you.

VOLATILE ASSET CLASSES

Our immediately previous essay covered this subject quite well. I can think of only one reason why anyone would want to add them, namely, increasing the overall profit potential of a portfolio. We achieved this goal in a portfolio with 2/3 stable and 1/3 volatile assets. Whether they should be used at all, or in a modest percentage, is completely up to the wishes of individual investors. A portfolio with 40% volatile components will have plenty of excitement and profit potential; whereas dropping the volatile components to 20% would probably not disturb the sleep of too many investors. We will continue to use volatile asset classes in our own portfolios and write about them in future essays.

PORTFOLIO BUILDING CAN BE GREAT FUN

We recently rediscovered a very old friend, PRPFX, the Permanent Portfolio fund. It has had a successful life of over 30 years and has a good chance of being here 30 years from now. It offers a rigidly fixed portfolio of U.S. and Swiss bonds, gold and silver bullion and 30% of U. S. stocks. It is possible to own this miniature stable/volatile portfolio with a $1,000 purchase. I had completely forgotten about this interesting fund as I was reinventing it during the past year. As I explain below, PRPFX should be in everyone's portfolio.

PRPFX has one weak spot that can be turned into a long term benefit. Its aggressive stock holding will probably produce a number of net loss years, but any young person starting a dollar cost averaging accumulation program should do very well in the long run. Any early losses in the stock position will simply lower the purchase costs in the early years of a long accumulation campaign.

The Permanent Portfolio fund, in a larger lump purchase program, should be in a group of perhaps six or more stable funds to obtain real diversity over an uncertain future. However, if backed into a corner by someone wanting serious diversity in only 3 funds, I would suggest the following quite diverse portfolio:

                PRPFX   40%
                HSGFX   30%
                HSTRX   30%  

                 Total     100%

All together, these 3 quite different funds will provide broad diversification over U.S. and  foreign bonds, U.S. income paying stocks, gold and silver. One portfolio has a fixed format and the other two are specially managed to prevent losses. In a tax free account, this simple 3 fund portfolio could be started with a modest amount of money and continued  for a lifetime or until the investor chooses a more exciting portfolio. Do not be fooled by the mutual fund ads that suggest different portfolios for each age of the investor. All you need is a portfolio that grows your money and never loses it.

This very simple portfolio will probably need rebalancing about every two years. This means returning the portfolio to its original percentage of the 3 funds.

A PORTFOLIO WITH TEN ASSET CLASSES IN 5 FUNDS

By adding the Prudent Bear and Prudent Global Income funds to the three above, we add a great amount of diversity and balance in fully managed short positions, precious metals stocks and short term foreign bonds. These five funds give a serious investor ownership of a fixed portfolio of six asset classes and of pairs of funds fully managed by David Tice and John Hussman, both proven managers. Here is the way I would allocate money to these funds.

                PRPFX   25%
                HSGFX   25%
                HSTRX    25%
                BEARX   12.5%
                PSAFX   12.5%

                 Total      100%

This five-fund portfolio has one volatile asset class not in the three-fund portfolio, namely about 10% of a fund that is short the market. It will require more frequent rebalancing, probably about once a year, and will add noticeably to the growth of the portfolio.

FINAL COMMENTS

If you succeed in completing the homework tasks listed above, you will be well on the way to knowing how to find a suitable replacement for a fund that is acting poorly or just goes out of business. Either or both of these causes may well happen in the difficult years that lie ahead. It is very important that you learn how to do it before it becomes necessary. The very fact that the list of excellent funds is small today, should convince our readers that they need to know how to find a replacement if needed.

It is good to remember that today’s small number of really excellent stable funds is a sad commentary on the misplaced priorities of the mutual fund industry. They have all been in a mad rush to beat their competitors in producing a new super growth fund for the new bull market. I hope that I have been able to warn my readers about the misleading and self serving fund ads.

I will appreciate your comments on whether this type of essay has been useful for you

Go Top

© 2004 Robert B. Gordon, Sc. D.
Dr, Gordon's Editorial Archive

Robert B. Gordon, Sc. D.
Sun City West, Arizona
March 3, 2004
Email

Financial Sense   Home  l  Broadcast  l  WrapUp  l  Storm Watch  l  About Us  l  Contact Us