The Theory Behind the Golden Butterfly


Perhaps because of how prominently it features in the Portfolio Finder, I’ve noticed a great deal of questions and conversations about the Golden Butterfly portfolio of late.  Rather than scatter my thoughts around the internet, I realized it might be best to provide a centralized synopsis of how and why it works so that everyone can benefit.

The Golden Butterfly is certainly unintuitive and goes against conventional investing wisdom.  Lots of people simply hate gold as an investment.   Long term treasuries are highly volatile for bonds and may lose significant value in the future.  Small cap value is controversial and countless conversations have debated its future performance.  Short term treasuries seem like a waste at today’s rates.  With four unpopular assets out of five, many people assume it’s a terrible way to invest.  Yet the results speak for themselves, and the remarkably consistent returns that are competitive with the stock market as a whole usually get people’s attention.


And if that doesn’t the withdrawal rates certainly will.  They cut so against the typical investing wisdom (which is generally based on an incomplete understanding of how safe withdrawal rates work) that most people have a very difficult time believing it can possibly be true.


That leads many people to assume that it’s just a result of data mining, and their natural instinct is to immediately seek out any possible outlying data that they believe must make it look so good.  The bond tailwind since ’81 is a common citation, as is the gold switch after Bretton Woods was repealed in ’71.  But thinking this way misses the fact that it also did very well when treasuries were crushed as interest rates skyrocketed in the 70’s, when gold lost 80% of its value in the 80’s and 90’s, and when stocks lost money for more than a decade starting in 2000.  So clearly there’s something more fundamental backing the consistent returns than a few great years.


For comparison, which portfolio is more buoyed by a few outperforming years?


As I mentioned in a previous post, the Golden Butterfly is built as an extension of the Permanent Portfolio.  So to understand how it works, let’s start with the foundation.

The basic theory of the Permanent Portfolio is to select assets that do particularly well in the four possible economic conditions. Generally speaking:

Prosperity: stocks
Recession: cash (or commonly short term treasuries)
Inflation: gold
Deflation: long term treasuries

Of course, assets are complicated and sometimes over-simplified labels don’t do them justice. My personal interpretation of the roles of each asset is actually a bit more nuanced than the classic Permanent Portfolio explanation, although I still think the core asset selection is truly insightful.

For example, some people rightly point out that gold is not necessarily the ideal inflation hedge that many proponents may believe.  That’s fine and I don’t necessarily disagree, but gold has other benefits as well — especially how it is negatively correlated to stocks and bonds.  So even if its inflation-fighting properties aren’t as consistent as some people claim, it’s still a valuable component to protect the portfolio when stocks and bonds are both struggling.  Think of the 2000’s when stocks went sideways for a decade with low inflation, but gold still responded and did great.

And in addition, I think it’s important to realize that assets can play multiple roles in a portfolio. In fact, perhaps the most impressive inflation-fighting asset on the list is the one most often overlooked by yield-chasing investors.  So rather than get too bogged down fitting individual pegs into economic sized holes, I think the key insight is that one should cover each economic condition with one or more assets that not only weather the storm but also thrive in that situation.

Of course, the flip side is that there will always be a situation where a particular asset struggles and it definitely pays to plan ahead.  Harry Browne liked to explain how the Permanent Portfolio protects your money from market turmoil by referring to the four very different assets as having “firewalls” between them.  So even if gold does terribly for a while, the damage is isolated only to a small portion of the portfolio.  And because the assets are selected based on economic conditions, when gold is struggling that usually means that at least one other asset is doing great and more than making up the difference.  Rebalancing along the way always buys low and sells high, generating returns in volatile markets even while individual assets struggle to maintain long-term growth.

Importantly, it works the same way when bonds tank and when stocks inevitably crash.  This outlook-neutral approach that doesn’t try to predict the future but instead protects you and grows your money no matter what the future holds is the core idea that makes it tick.  For more information, I particularly recommend “The Permanent Portfolio: Harry Browne’s Long-Term Investment Strategy” by Craig Rowland and J. M. Lawson. 

The Golden Butterfly follows the same philosophy.  To summarize:

Invest in volatile uncorrelated assets that cover every economic condition, and you’ll do pretty well with limited downside no matter what happens in the markets.

The difference is that it tilts the portfolio slightly towards prosperity, the most common of the four conditions.  And it does so by intentionally selecting an additional stock asset that complements the normal Permanent Portfolio stock index fund for rebalancing purposes and higher overall returns.

The large/small barbell works well for this but other options are also fine.  The permanence of the value premium is also debatable, but it is not central to the portfolio and other options like small cap blend or a broad international fund also work.  Play with the Portfolio Finder for a while, and you’ll see lots of portfolios resembling the Golden Butterfly with two parts stocks, two parts bonds, and one part gold, commodities, or REITs.  The concept of not placing your bets for the future on any one economic condition is more important than any individual asset.

It’s that last concept that generally distinguishes investors who find the Golden Butterfly interesting versus ones who think it’s a terrible idea.  If you’re the type of person that believes “stocks always make the most money in the long run” then the Golden Butterfly probably does not seem very appealing with only 40% stocks.  And depending on your outlook for the future you may really not see much hope for long term treasuries, gold, and cash any time soon and will find plenty of reasons to look elsewhere.

But if you’re the type of person who has no idea what the future holds and wants a portfolio that will protect and grow your money no matter what happens, then the Golden Butterfly may be a portfolio you’ll appreciate.  I can’t guarantee it will continue to match the stock market in returns over your investing lifetime any more than I can guarantee the stock market won’t tank again for another 13 years.  But with the Golden Butterfly you’ll be better prepared for any outcome than many alternative options.

In the grand scheme of things, it’s really the variety of those options that matters most.  Even if the Golden Butterfly is not for you, that’s fine!  There’s no such thing as a single perfect portfolio and there are many good options out there.  But whether or not you ultimately choose this one for your own life savings, I believe all investors should take the time to understand and appreciate its outlook-neutral approach.  The Golden Butterfly is more than just a pretty face, and perhaps by utilizing some of the same thought processes you can help prepare your own preferred portfolio for an uncertain future.

UPDATE: This post was updated on 9-28-2016 with up-to-date data and modified withdrawal rate terminology, and on 9-18-2017 with a few clarifications on asset roles.  It’s a popular post and I do my best to keep it as accurate and helpful as possible.