What we are doing here is creating a diversified portfolio, using stocks and bonds as most investors do, but also adding gold as an insurance policy against threats to the system itself, such as those we saw in 2008 and 2009. We are then taking that diversified portfolio and, every month, using the 200-day moving average to determine whether each asset class is at risk of a significant decline in the near future. If it is, we are moving that part of the portfolio to cash.
From a Wall Street perspective, we can view this approach as the Permanent Portfolio idea combined with a moving average overlay. Each idea has power individually, as we have seen, but together they are more effective in managing drawdown risk, allowing us to meet our initial goal—of keeping portfolio losses to a maximum of 10 percent—even in the worst circumstances.
By keeping the stock allocation to 33 percent, we limit our upside, but we also limit our risk. Moreover, by using the moving average strategy, we keep our average returns high enough that the lower allocation is sufficient for our needs. By allocating 33 percent to bonds, we maintain a steady stream of interest income, as well as the potential upside if the economy weakens. By adding gold, we insure against the possibility of risk to the system as a whole. Finally, by being willing to go to cash, we add another layer of safety.
Is this a perfect system? Of course not. It has real costs, with taxes potentially being the largest. It has real risks, notably of underperformance in bull markets. It is not perfect, and it is certainly not for everyone.
It is, however, designed for one particular investor—the one who needs stock market exposure but can’t bear stock market risk. For the retiree, for the college saver, that reduced drawdown risk can more than compensate for the real costs and risks of the strategy.
For the Main Street investor, what matters is the destination. That is the idea of this book. By adding seat belts to your portfolio, you can help improve your chances of getting where you want to go with a minimum of risk.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.