This user’s experienceby Matt Henderson, since 2003

In his excellent book, “Innumeracy,” John Allen Paulos presents a number of surprising and important consequences of our general lack of understanding of the principles of mathematics; particularly, statistics, probability and the influence of large and small numbers.

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Each person who makes the decision to save, must decide where to store his savings. Should we put them in the bank? Should we stuff them in a mattress? Should we buy real estate, or perhaps works of art?

Cash in a bank will lose value over time due to inflation. Value in a real estate isn’t very liquid. Money invested in a company’s stocks can be lost in a bankruptcy. In general, modern investment theory speaks with a uniform voice — we should allocate our savings across a diversified mix of (ideally uncorrelated) assets. But which assets?

Conventional wisdom — stocks and bonds.

Almost all of the leading investment experts (Malkiel, Bernstein, Bogle, etc.) recommend that we allocate our savings primarily across stocks and bonds. Within this camp, a few peripheral voices recommend mixing in small quantities of alternative investments such as commodities or real estate investment trusts, for their diversification benefits.

In addition, the particular proportion of stocks and bonds is important, as it defines one’s expected “risk” level. A portfolio of 80% stocks and 20% bonds will provide far greater opportunities for gain than a portfolio of 20% stocks and 80% bonds. At the same time, however, it also provides opportunity for far greater loss.

The experts insist that each individual must assess his own level of acceptable risk when choosing a particular allocation, and that we must monitor and adjust accordingly over time, as we get older or as our circumstances change.

Will the future look like the past?

While I am undoubtedly certain of the importance of diversification, I’ve always had two fundamental problems with asset selection conventional wisdom:

• First, the particular assets of stocks and bonds have been chosen solely because of their historical performance. For as long as we’ve had data available (more than 100+ years), a mix of stocks and bonds would have outperformed other passive investment vehicles available to us. But, what if the future doesn’t look like the past (at least within my lifetime)?

• The second problem I have is a lack of confidence in my own ability to assess my own level of “acceptable risk,” and to adequately monitor and manage that risk over time.

An alternative — the Harry Browne “Permanent Portfolio”.

In part due to these doubts, I became attracted to the investment philosophy of Harry Browne — a successful investor, writer, and Libertarian politician from the mid-1970s through late 1990s — introduced in his book, “Fail Safe Investing.”

Harry Browne’s approach begins with the question: What are our objectives for the wealth we consider precious? On that, he had two answers:

• Protection. We don’t want to lose our savings, under any circumstances.

• Growth. If possible, we should try to grow our savings, at least enough to compensate the erosive effects of inflation.

Then — and this is key — rather than selecting assets by looking backwards, he selected them looking forward. He asked, “What are the possible states of our economy? And for each of those states, which is the asset that responds most dramatically?”

He identified the following four states of the economy, and corresponding optimal investment assets:

• Prosperity. In times of prosperity, stocks perform well. According to the principle of diversification, he recommended (as do most experts) investment in passively managed mutual funds or ETFs that track broad market indicies.

• Inflation. In times of strong inflation, when the purchasing power of our paper currency is being eroded (and in times of political or currency crisis), gold does well. He recommended owning physical gold, although owning it in a more convenient alternative (such as an ETF) is also acceptable.

• Deflation. In times of deflation, when interest rates and prices are dropping, the value of bonds increase. The sensitivity of bond prices to such conditions is a function of the bond duration — the longer the better. Furthermore, we need to be holding bonds that can’t be called. In such times, we therefore need to be holding long-term government bonds — e.g. 20 year US treasury bonds.

• Recession. In times of recession, almost all investments decline. During such times, we need a cash cushion to sustain ourselves, and with which to buy up those other assets that are temporarily dropping in value.

Browne recommended that we divide our savings equally among those four assets, and periodically sell those that are doing well, and buy those that are doing poorly — a critical process known as “rebalancing” — in order to maintain that equal 25% distribution of savings across each.

This portfolio, known as the Permanent Portfolio is attractive for a variety of reasons. It is simple. It is permanent. It doesn’t require self-assessment of risk or time-frame. It contains at least one asset that should be doing well at all times, and which historically has carried the portfolio as a whole. Finally, through modern ETFs, it’s very easy to own this portfolio, at extremely low costs.

But how does the Permanent Portfolio perform?

How has the PP performed historically? Very well, in fact! Since 1964, the PP has returned an average of 8.5% per year; quite respectable compared to the 8.8% return of the common 60/40 stocks/bonds portfolio. But whereas the common stocks/bond portfolio lost 30% of its value in the crash of 2008, the PP lost only 1.3%. (You might want to pause, to contemplate that last point.)

In fact, the Permanent Portfolio has prospered during both bull and bear markets, in a manner that has been very stable.

So what’s the catch?

One might wonder, as I often have, why more experts don’t recommend the PP, and why more people don’t invest in it?

Regarding the second question, the PP has a big issue working against it — tracking error. It’s ups and downs will not mirror those of the general stock market, and so when stock-heavy investors are boasting of their big returns in a given year, the PP holder will more likely than not be looking at more meager growth. For this reason, investing for the long-term in the PP requires determination and fortitude.

That I have no problem with; I can stick with a plan. The other question has long bothered me more — why don’t the other investment experts, for whom I have such respect and admiration, give this portfolio much thought or attention?

Well, this past week, one of those investors, William J. Bernstein, did just that — he published an article about the Permanent Portfolio, in which he refers to it as, “a thing of beauty.” In fact, the main problem he has with the PP is precisely what I mentioned above: It’s hard for most people to stick with it, over the long run. Reading that article made my day.

There’s a lot more to the permanent portfolio (and investing in general) than I’ve covered here. For general investing, I’d recommend Bernstein’s book, “The Investor’s Manifesto”, and for information about the permanent portfolio, the best starting point is the Crawling Road blog. (The Crawling Road forums are great.)

I really enjoyed watching this video of Paul Graham at the 2009 Business of Software conference, in which he discusses 21 future trends he believes we can bank on. Having grown and sold an early web business to Yahoo, Paul has since become a highly influential writer and participant in the technology industry. Currently, he runs “Y Combinator,” a venture capital company which makes financial and advisory investments in startups.

In his talk, I was excited to hear Paul emphasize the importance of some areas in which I’m invested, both personally and professionally:

• OS X on the desktop. Paul points out that open-source, while a great model for the development of technical solutions, falls short at the boarder with design, because of the human psychology aspects which are central to good design. For that reason, he believes (as I’ve long believed) that Linux will never have a place on the desktop, and, of the remaining options, Mac OS X is and will continue to be the clear winner. (He also notes that over 50% of his audience was using Macs — perhaps an early indicator of broader future market trends.)

• The iPhone will be a huge deal. Paul believes the iPhone has no competition, and is unlikely to see any competition in the near future — because it’s the top priority of the world’s best design company. He also believes this is a tragedy for such a hugely important emerging market (i.e. mobile), because of Apple’s application approval process, which is pretty much the anti-thesis of free markets. (Interestingly, he points out that the central thing going against Android is that it belongs to Google — since a firm can only have one top priority, and for Google, that’s search.)

• Bet on design. As more and more of our daily lives involve interaction with software systems, the scope of design will continue to increase, and the need for good design will become ever more important. He points out the unfortunate curiosity about design — that everybody believes they’re good at it, and in that respect, it’s quite different than, say, the engineering or medical fields. (Nobody, other than trained physicians, feel they’re “probably good at surgery.”)

I strongly agree with Paul on all these points, especially the one about design. And that’s particularly exciting for me, as design is both a personal passion, and a (if not the) fundamental value of my company.

On a closing note, as clever as he is, Paul didn’t get it right on all fronts. At 41:30 in the video, talking about the coming importance of real-time, he says, “I think Google Wave is going to be important.” On that, he must have momentarily forgotten his earlier emphasis on the importance of good design. Oh, well, nobody’s perfect.