Icelanders with a traditional 'defensive' portfolio, consisting of only stocks and bonds, destroyed their capital in 2008. Icelanders that had everything on a savings account can buy 3 times less. The Icelander with a permanent portfolio however was relatively well protected and can now buy 40% more real estate.
The permanent portfolio consists of 25% stocks, 25% bonds, 25% cash and 25% physical gold. The Icelandic government was on the verge of bankruptcy, giving government bonds a serious blow. Stocks and corporate bonds completely imploded while inflation exploded due to the currency collapsing in value.
No better scenario imaginable to test if the permanent portfolio protects you even in such disastrous economic climates. We will study how the 4 assets in the permanent portfolio performed.
The returns for Icelandic stocks for 2008 speak for themselves:
The stock market fell through the floor from 5671 points to 582 points, a loss of 88%.
The 25% bonds are invested in long-term government bonds. The longest-term government bond in Iceland available before 2008 ran until 2019, so this is a duration of only 11 years. Here what the bond did in 2008:
Source: Central Bank of Iceland, Bonds.is / LT Bonds
This is really interesting. Look how the market was completely disoriented. When the collapse began in September everyone first fled from the collapsing banks to the safety of long-term government bonds and pushed up the price explosively from 90 to 130, up 50% in less than 15 days.
But this soon proved illusory. Due to taking over and giving guarantees to all the banks their very own state was suddenly on the verge of bankruptcy. If the government goes broke you lose your government bonds in the process. So all participants reversed their trade and started to sell off those bonds like never before. All profits from the previous month went down the tube and then some more ... . The long term government bond tanked from 130 to 70, a loss of 45% in again a few days.
Towards the end of the year it was clear that the Icelandic government itself got a 'bailout' from the IMF, as well as different other countries, and the value of the 11 year government bond restored back from 70 to 92. 2008 results for the long-term government bond for an Icelander looks at first sight quite okay with a drop in value from 100 to 92, only 8.6% off. This bond also yielded an interest of 8.75%, so that compensates for the loss. The end result is 0%. No profit but also no loss.
The 25% cash portion is invested in short-term government bonds. The shortest duration government bond ran from June 2007 to June 2009. Here is the chart for that bond's performance in 2008:
Source: Central Bank of Iceland, Bonds.is / ST Bonds
The short-term government bond was worth 93 points starting 2008. At the end of the year it was valued at 97 points. You also got 8.5% interest giving you in total 97 + 8.5 = 105.5. An increase from 93 to 105.5 makes a yield of 12%. A strong performance at first sight.
What was the performance of gold? This directly depends on the value of the Icelandic krona. Here is a chart from the krona relative to the euro:
Source: European Central Bank
Starting in 2008 you paid 90 krona for 1 euro. At the end of 2008 you paid 290 krona for 1 euro. A staggering 69% drop in value. Starting 2008 gold was priced 530 euro per ounce. At the end of 2008 gold was priced 592 euro per ounce. In Icelandic krona gold therefore was valued at the start of 2008 47,700 krona per ounce (530 euro/ounce x 90 krona/euro). At the end of 2008 gold was valued at 171,680 krona per ounce (592 euro/ounce x 290 krona/euro).
Now, the rate of the krona versus the euro and all other currencies is food for discussion. The European Central Bank stopped publishing the exchange rate of the Icelandic Krona on December 9, 2008 because the Icelandic government did not allow their currency any longer to be valued by the free market as in their opinion it was not priced 'correctly'. So they forbade others to exchange the krona in the free markets and became the sole exchange issuer with a rate decided by them (which ofcourse was a lot higher than what the free market decided it to be). However, since there are limits in the amount of krona you can sell as the Icelandic governement wants to avoid the krona is being sold, the official rate is not necessarily the true rate that is being payed on the 'black market'. The black market being the only place where you can still can get rid of your krona.
Rightfully so, instead of publishing the new exchange rate, the European central bank opted to not publish the exchange rate any longer. For our calculations of the permanent portfolio it is sufficient to use the last free market quotation, that was close to the end of the year at December 9, 2008, to already see what happened in 2008. Gold is up from 47,700 krona to 171,680 krona, a staggering 259% return.
So what is the total picture? Here the results for the 4 assets of the permanent portfolio in Iceland:
- 25% Long Term Government bonds = 0% = 25 x 1 = 25
- 25% Short-term government bonds = 12% = 25 x 1.12 = 28
- 25% Stocks = -88% = 25 x 0.12 = 3
- 25% Gold = 259% = 25 x 3.59 = 90
- Total = 25 + 28 + 3 + 90 = 146 = 46%
So the 100 krona at the start of 2008 became 146 krona, a yield of 46% for the permanent portfolio. However what is a krona still worth? The Icelandic central bank claims that inflation has risen from 5% to 18% in 2008. So if you take their figures that 146 crowns needs to be deducted by 18% as that is what a krona dropped in value for the year. This means you only have 120 kroner purchasing power. Still quite well as according to these figures your purchasing power went up by 20%.
However, if you take the figures of the European central bank inflation of the krona against the euro was 69%. So the 100 krona in early 2008 could still get you 1.1 euro. But those 145 krona you had at the end of 2008 could only get you 0.5 euro. In other terms, even with 46% yield, you still lost 55% purchasing power in the Eurozone even though you had a permanent portfolio.
Since the euro dropped 10% in value versus the dollar in 2008 it's even worse in dollar land. You lost 76% purchasing power in America and versus all trading partners that want to get payed in US dollars. Because obviously trading partners want dollars or euros all imports skyrocketed in price by a modest 200%.
A fridge, food, cars, gasoline, computers, clothes, and almost any other item in the stores just tripled in price as most of them are imports. So, even with a permanent portfolio you lost serious purchasing power versus imports. However, with the permanent portfolio you did win purchasing power versus local goods, services and real estate as these prices did not go up but stayed flat or went down.
For example, eventhough the currency collapsed, real estate did not triple in price but instead started to fall in price:
In January 2008 residential real estate was still going up by 14,4% on a yearly basis. But at the end of 2008, in December, prices of real estate were already falling at a rate of 2% on a yearly basis. So in krona house prices stayed flat in 2008. But since the krona lost 18% in value prices after inflation fell from 213.8 points to 179.8 points or a loss of 16% in purchasing power according to the central bank of Iceland.
The Icelander with a permanent portfolio did not lose purchasing power in relation to houses, more to the contrary, where houses had fallen by 16% in purchasing power after inflation, the permanent portfolio increased it's purchasing power by 20% after inflation. Meaning, an Icelander, that invested his money according to the permanent portfolio principles, can now buy 40% more real estate.
So with the permanent portfolio you did lose a lot of purchasing power versus imports, but you gained purchasing power versus local goods, services and real estate. What happened if you did not have a permanent portfolio but instead a safe traditional 'defensive' portfolio consisting of 25% equities and 75% mostly corporate bonds, like many people do?
The stocks simply disappeared, only 10% of the value remains, meaning if you invested 100 krona, of which 25 krona went to stocks, only 2.5 krona remains from the stocks. The other 75 krona you invested in corporate and some government bonds. Most of these corporate bonds were financial bonds as these dominated the economy. These financial bonds were all on the verge of bankruptcy. The same was true for many other Icelandic companies and their bonds.
Since financial bonds in Europe and USA dropped in value by -50%, and many other corporate bonds by -5%, I think it is safe to estimate the loss of Icelandic corporate bonds to be at least -5%. Taking into account that some bonds were government bonds that performed better, I think it is safe to estimate a loss of -5% for the 75 krona bond part leaving around 70 krona of your bond part intact after 2008.
A rough estimate gives you 2.5 krona from the stocks + 70 krona from the bonds, you only have 72.5 krona of your capital remaining. Real estate for example stayed flat in krona, so you just lost 28% purchasing power versus real estate with your 'defensive' portfolio.
Since in euro and dollar terms that 72.5 krona is worth 69% less you only have 24 krona remaining of your purchasing power versus the dollar/euro. You lost 78% of your purchasing power in one year versus imports. And that was for a 'defensive' investor.
No, a traditional 'defensive' portfolio is a downright disgrace. Everyone that still has such a monster today, can better quickly realize it!
Lets not think about what happened with a 'neutral' investor with 50% stocks and 50% corporate bonds. Or an 'aggressive' investor with 100% stocks that followed his financial adviser's opinion that 100% stocks is the best strategy when 'you are still far from retirement'. He lost 90% of his purchasing power versus local services and real estate and lost 97% of his purchasing power versus imported goods. That is not only an economic depression but a personal depression. What you have worked for, and saved for, your life long, is gone. FAR from retirement indeed!
Everything on a savings account was equily a poor investment decision. Your bank was in the news with enormous loses and scandals. Rightfully you feared to lose everything but then the bank got nationalised saving your account. Although you preserved your capital and had by estimate around +10% interest this was still below official inflation that turned out to be 18%. You therefore lost 8% purchasing power versus local goods and services but since houses lost 16% after inflation you gained 8% purchasing power versus real estate. However like anyone else your krona was worth 69% less and so your 110 krona could buy you 65% less imported goods as your 100 krona one year before.
The permanent portfolio also got a serious beating. Expressed in euros, 50% of your purchasing power is lost. Also painful, but you still have 146 krona instead of 110 krona like the saver, meaning you have 30% more purchasing power than a savings account. You have 146 krona instead of 72,5 krona for a traditional 'defensive' portfolio investor, meaning you now have more than double his purchasing power. You quadrupled your purchasing power versus a neutral investor with 50% stocks and 50% bonds and fifteen folded your purchasing power versus a traditional aggressive investor with 100% stocks.
The experience in Iceland shows that the Permanent Portfolio is unable to perform miracles. It remains a fact that an Icelander, even with the permanent portfolio, can buy a lot less imported goods. However, its relative purchasing power compared to other savers and investors went up considerably.
Also, you need to put everything into perspective. What happened the previous 10 years in Iceland? Here what stocks did from 1999 until 2008:
Until 2003, the stock market acted in parallel to other western stock markets. A serious increase by 50% in 1999, after which the dotcom crash destroyed all that. However, since 2002, the Icelandic stock exchange took an euphoric ride on their own. It rose from 1100 points in 2002 to 7500 points in 2007. While in the rest of the Western world stocks went up in 5 years by 100%, they rose 700% in Iceland.
They transformed themselves from fishermen to financial gurus and all believed it. An Icelander that followed the permanent portfolio strategy was forced during those booming years to do exactly the inverse of what the euphoric masses did. The annual rebalancing forced him to sell stocks five years in a row and buy government bonds and gold with the proceeds.
The amount of government bonds and gold that you purchased in that period was significant given the enormous profits that your 25% stocks each year delivered. You bought a lot more gold than, for example, a European or American with a permanent portfolio. Although your performance was much lower than the 'aggressive' Icelandic investor with 100% stocks you were exactly doing what was needed to save you from the coming collapse. Namely, converting those stock profits into valuable gold, the one asset that would save him later on.
Also interesting is what an Icelander with a permanent portfolio was REQUIRED to do at the start of this year. He had to sell the vast majority of his gold and buy a completely new package of bonds and especially stocks so that the ratio was back to 25% for each asset. Not a bad decision when the stock market just dropped 88% and was now 50% lower than 10 years ago. Not a bad decision to buy bonds when long term governement bonds now return 15-20% interest. But ofcourse that is speculation as we don't know what the future will bring in Iceland.
One thing however is for sure, you are again acting against the trend. Because believe me, after you just lost your life savings in stocks and bonds there is not much appetite to buy them again, at the start of the next year. No, Icelanders are in SHOCK mode trying to understand what just happened to them.
Update 4th of June 2010:
Here the results for the Icelandic PP from 2003 untill 2009:
Purch. Power means the total returns from 2003 till 2009 after deducting 'official inflation' (which is underestimated).
Update 4th of June 2010:
Here the results for the Icelandic PP from 2003 untill 2009:
Purch. Power means the total returns from 2003 till 2009 after deducting 'official inflation' (which is underestimated).
