Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:38]

Thank you, Mary, and welcome to episode 102 of Risk Parity Radio.

Mostly Voices [0:46]

Today on Risk Parity Radio, I'm intrigued by these, how you say, emails.

Mostly Uncle Frank [0:50]

And our first email of the day, or as my buddy Rex likes to say, First off,

Mostly Voices [0:57]

we use the buddy system. No more flying solo.

Mostly Uncle Frank [1:01]

First off, we have question for Uncle Frank from Andrew and Karen. And they write, sorry one follow up to my prior email. Again, concerning fees with changing financial institutions or rebalancing also likely cause double charges on the maintenance fees due to repeat or additional purchases. Many thanks, Drew. Well, this follows up on an email we talked about in episode 97 about how fees are taken out of ETFs. And the answer is they are taken out on a daily basis. So, no, your rebalancing or buying or timing of buying will not affect your fees.

Mostly Voices [1:44]

Ain't nothing wrong with that.

Mostly Uncle Frank [1:47]

Thank you for that email. Second off, we have an email from Nick and Nick writes, hi Frank, I hope you might have the interest to address this article in one of your upcoming podcasts. I think many of the folks considering a transition into a risk parity portfolio may benefit from understanding what we would consider adding long-term treasuries or why we would consider adding long-term treasuries to our drawdown portfolio in light of the opinions expressed in this article. Is it true that the negative correlation between VTI and TLT is getting closer and closer to positive correlation? If that is so, that would be of concern to me in moving ahead of holding TLT. Thank you for your time. And he links to an article from Seeking Alpha. I will not tell you what the article's author's name is, but I will link to it in the show notes. But I did take a look at this article.

Mostly Voices [2:43]

Well, I like to do the job right.

Mostly Uncle Frank [2:47]

And it starts off pretty well describing treasuries and what they do. And it says, Treasuries generally outperform during downturns, recessions and equity bear markets. This makes them strong, effective equity hedges, at least most of the time, a significant benefit for their investors. This was the case during early 2020, the start of the coronavirus pandemic and attendant recession slash bear market. It was also the case during the past financial crisis. And it was also the case in the early 2000s, but he didn't add that. The numbers all go to 11. Then he writes, more broadly, long-term treasuries are generally negatively correlated to equities. So the pattern above holds when equities are down, treasuries are up. So you can use treasuries to hedge your equity holdings. You are correct, sir. Yes. And then he writes, Danger, Will Robinson, danger! During 2021, long-term treasuries have actually been positively correlated to equities. Downside protection has been and is likely to be low to non-existent. And I feel like he's getting too clever by half there. My name's Sonia.

Mostly Voices [3:56]

I'm going to be showing you the crystal ball and how to use it or how I use it.

Mostly Uncle Frank [4:00]

I'll just address this now. That's actually not true. I went and did a correlation analysis, and I think he kind of screwed up his correlation analysis because if you're going to take such a short time period, you have to do it on a daily basis with as short or rolling correlation you can do at Portfolio Visualizer. That's 20 trading days. I'll link to this in the show notes. But basically for this period, it shows that TLT has essentially a zero correlation with the stock market, it's uncorrelated. It comes in at 0.06. But more importantly, if you compare it to other things like a small cap value fund, it shows a negative correlation of 0.28 on the correlation scale of negative 1 to positive 1. So he's just wrong on where he got his data.

Mostly Voices [4:49]

You can't handle the crystal ball.

Mostly Uncle Frank [4:53]

But this does seem to be him reaching to try to find some reason not to hold long-term treasuries now. as if they are different than before because some crystal ball has appeared in 2021 that says something different than what was before and that crystal ball is going to be the right crystal ball going forward and we can just ignore everything that happened in the past. As you can see, I've got several here, a really big one here, which is huge. This is the one that I tend to use more often.

Mostly Voices [5:31]

I have a calcite ball and I have a black obsidian one here. It's kind of looking at the aura around the ball. See the movement of energy around the outside of the ball.

Mostly Uncle Frank [5:43]

So this is a badly reasoned article. That's not how it works. That's not how any of this works. The other data he should have looked at is the actual data of the performance of these various assets over the course of the past six months since he's talking 2021. Yeah, let's just talk 2021. You keep using the word. I don't think it means what you think it means. If we look at the various things we use in our risk parity style portfolios, we see that small cap value funds are up about 25% these days. The REITs that we represent with REET are up slightly less than 20%, like 18% since the year beginning. The SPY, the S&P 500 itself, is up about 12%. And then we look at the less correlated or uncorrelated assets that we talk about. Long-term treasury bonds are down about 10%. Gold is down about 8%. So that is actually exactly what you would expect out of this style of portfolio because you have more stocks in it than you have bonds or gold. So your overall, your portfolio is going to go up. Yes, it's not going to go up as much as it was all stocks, but when it's going down, you'll see this thing reverse. And so the idea is you're lowering your volatility overall. But if you don't acknowledge what's actually going on like this author did, and you have some mental block or confirmation bias in your head, then yeah, you're going to get the wrong answer and you're going to go, find some spurious data that supposedly supports what you have to say, or when it's just wrong. Do you think anybody wants a roundhouse kick to the face while I'm wearing these bad boys? Forget about it.

Mostly Voices [7:33]

Forget about it.

Mostly Uncle Frank [7:37]

And then he writes in his conclusions why you shouldn't be holding treasuries. He is still claiming that the correlation is breaking down or lack of correlation is breaking down. He says that first is the fact that treasury yields are already at historical lows and could scarcely go lower. This severely limits potential capital gains, which limits their effectiveness in a downturn. In other words, if equities go down, don't expect long-term treasuries to go up by a lot because the price is already almost as high as they could feasibly be. Now again, this is also wrong. Wrong! And if he just went back to early 2020, he could see that he was wrong again. Because if you look and see what long-term treasuries did in that period in early 2020, the interest rates only need to go down about a percent for this to have a nice impact in your portfolio. And if that happens, your treasury bonds are going to go up by about 20%, 25%, depending on exactly what you hold. And what's even more interesting about it, and another thing that he's unaware of, is that this effect becomes even more pronounced as you get closer to zero. This is what is called bond convexity. And I'll link to an article in the shownotes that the closer you get to zero, the bigger pop you're going to get if these things go down to what they have before. So yes, they could go up a lot even at these low rates if there is another recession, coronavirus, or some other reason for it.

Mostly Voices [9:12]

I said consummate these. Consummate. Jeez, guy wouldn't know majesty if it came up and bit him in the face.

Mostly Uncle Frank [9:19]

And then he writes another of his reasons not to hold treasury bonds. Second has to do with the effects of inflation on equities and rates. MSCI has done a lot of work in this area and they've found that inflation generally drives both treasuries and equities lower due to expected realized discounted Federal Reserve rates. The fact that moderate inflation drives both equities and Treasury's down is well known but rarely considered by investors as inflation has been rare for decades. Again, this guy's just wrong. Wrong! He needs to go actually look at some data instead of repeating something that is not based on data that somebody else's say so. And it's when this sort of repeating of opinions without actually looking at the data, that's where people go wrong. That's where they start believing things that aren't true.

Mostly Voices [10:10]

Everyone else, however, is insane and trying to steal my magic beans.

Mostly Uncle Frank [10:16]

In this case, if you go back to the 1970s, you'll see that when Treasuries were doing poorly in an inflationary environment, you had other things like small cap value stocks and REITs and things that commodities, other things that were doing just fine. In fact, that was a golden age for gold, for instance. I love gold.

Mostly Voices [10:35]

So if you have other things that are diversified,

Mostly Uncle Frank [10:39]

they're going to perform well in that environment. you're going to be just fine. It's just not true that equities do poorly in moderately inflationary environments. In fact, they do extremely well in moderate inflationary environments, such as you had in the 1980s and in the 1990s.

Mostly Voices [10:58]

That's not how it works. That's not how any of this works.

Mostly Uncle Frank [11:06]

So I'm sad to say that this author is just wrong, but I read a lot of these articles and when I read them, I'd say, well, that's not what the data says. And if the data doesn't say that, then all you're really saying is you now have this crystal ball that things are going to be different somehow in the future. A crystal ball can help you. It can guide you for reasons of inflation or some other reason that you magically come up with, tell a story about and say, well, this is possible. Well, that's a cognitive bias called the possibility effect. Just because you can tell a story about something, and say it's possible doesn't mean it's likely. That's not how any of this works.

Mostly Voices [11:44]

It just means you can tell a good story.

Mostly Uncle Frank [11:47]

So we need to stop telling stories looking at crystal balls and just focus on what we know has been true in many earlier periods. Because assuming it's not going to be true is not a good assumption. It's just not. You will find that it is you who are mistaken about a great many things. And thank you for that email because it's good to confront these things when we see them and to recognise when someone is telling stories and not using data or cherry picking data, because it happens a lot it happens all the time.

Mostly Voices [12:43]

All right, third off, we have an email here from Chris and Chris writes,

Mostly Uncle Frank [12:50]

Greetings, I just discovered your podcast. Great stuff and I'm just starting to dig in. The one thing I've always struggled with is if you have two negatively correlated funds, as one goes up and the other will be going down and vice versa, and if you've got a 50/50 stock bond portfolio and they're going in opposite that directions to the same degree, you're going nowhere. I recognize this is unlikely, but it is why I've been investigating options that are uncorrelated rather than negatively correlated. While they may head the same direction some of the time, that will not always be the case. In any event, no need to respond, but I'm looking forward to learning from your podcast. Thanks for doing it, Chris. Well, of course I'm going to respond. This raises very interesting issues about how these asset classes actually work. For any fund or asset class that you can buy, there are really three factors in play when you're thinking about how does this work in a portfolio. One is that correlation with your other assets. Is it positive, is it negative, or is it close to zero? The second is the return of the asset class. Some asset classes like cash have really no return and short-term bonds are pretty far down there and other asset classes have historically larger returns. Stocks have some of the most significant returns of commonly held asset classes. So that's the second factor. And then the third factor is the volatility of it. And you'll generally find that things that are high return also have higher volatility and things that are lower return also have lower volatility. How this plays into your portfolio is that it's like a vector. What is a vector? A vector is a mathematical representation of something that not only has a direction, but it also has a power or amplitude in that direction. So it's the difference between an arrow that points to a unit of one and one that points to units of two. The vector that is twice as large has twice the effect. And that is the way your returns and volatility work in your portfolio. If you could think of each of your asset classes having a vector from zero pointing to both return and volatility, it tells you that things that are low volatility and low return are going to act like ballast in the portfolio. They pull it down both in terms of the return and in terms of the volatility. And that is undesirable when you're really trying to construct a portfolio that is diversified. If we can just think about giving you an example. So if you had a all equity portfolio, 100% equities, you'd expect it to return about 10% nominal. Now what if you just hacked that in half and made half of it cash? Your volatility would go down by half, but your return would also go down by half. It's a linear relationship and you'll find that anything you stick in your portfolio that is close to cash, that has a low return and a low volatility, is going to have that linear effect both reducing return and the volatility at the same time. What we're trying to do in constructing risk parity style portfolios and working with the Holy Grail principle of uncorrelated assets is to reduce the volatility much more than we're reducing the returns. So if you look at something like the Golden Ratio portfolio or Golden Butterfly portfolio, they are basically reducing the volatility by half But only sacrificing about 15% of the return. So instead of having half the return and half the volatility like you'd have in a stock cash portfolio, you get to have 85% of the return with half of the volatility. And that's the whole goal here. That's what we're trying to do.

Mostly Voices [17:04]

Go and tell your master that we have been charged by God with a sacred quest.

Mostly Uncle Frank [17:10]

It's hard to figure that out just looking at assets in a vacuum, so you do need to combine them and see what the results have been for particular combinations of assets. But what you'll find is that the more interesting assets are the ones that are low correlated or negatively correlated but have relatively high volatility because their vector is pointing further and harder in that opposite direction from your main driver. In most cases, we're talking our main driver of returns is still having stocks in our portfolio between 40 and 60%. And so the other stuff in there is used to balance that out. And if it has higher volatility, like long-term treasury bonds in a different direction, then you just need less of it and you're going to get better returns with much lower volatility than you would if you were to pick something with low returns and low volatility. But this really does go back to one of our core principles, that Holy Grail principle. We talk about this in episode seven and there is a video by Ray Dalio about the Holy Grail principle. I will link to it again in the show notes. But it's worth looking at and worth thinking about because it's not just the correlation that matters. The return matters and the volatility matters. And I think this is probably the number one conceptual mistake that people make when they're constructing portfolios. Because they think that, well, I'll just, you know, put some short-term bonds or cash or something in there and that'll fix my problem. Well, it'll fix your problem a little bit, but it'll really reduce your returns a lot more than you want or need to. And then you're going to have a lower safe withdrawal rate. That's not an improvement. Because the safe withdrawal rate is in turn determined by your return and your volatility. So you want the lowest volatility you can have with the highest return you can have. And when you have that, you have a higher safe withdrawal rate.

Mostly Voices [19:09]

Yeah, baby, yeah!

Mostly Uncle Frank [19:12]

So thank you for that email because it gets back to one of our core principles.

Mostly Voices [19:17]

Yes! Real wrath of God type stuff.

Mostly Uncle Frank [19:21]

All right, we'll just do one more email today. Make it a short one. Last off. A short episode. This is a longer email. And this comes from Brandon S and it's a question for Uncle Frank. And Brandon writes, hi Frank, questions for you. I heard Paul Merriman mention there could be an argument for not rebalancing an all equities portfolio during the accumulation phase. Just buy them and let them ride and forget about it. This is what I've been doing. Wait a second. Did he say forget about it? Forget about it. Forget about it. Bow to your sensei. This is what I've been doing, but I am missing out on returns by not rebalancing my equities, or am I? Asset classes include small cap, large cap, small value, REITs, and international developed value and emerging. I try not to mess around and screw things up too much, just auto invest in my bank account into Vanguard and take in paycheck 401k contributions. I recently considered converting my taxable brokerage account index mutual funds to their ETF versions. Vanguard reports this is not a taxable event. I was surprised. I recently have learned some of the benefits of tax efficiency of ETFs and brokerage accounts. However, the Vanguard rep told me that I cannot purchase future ETFs with auto investing. Since it's a trade, I have to place my buy for each fund each month. Curious if other companies work the same way, a bit of a bummer. Do the tax benefits outweigh the benefits of auto investing? I don't think about it or have a chance to second guess my contributions. Also, the rep said I need to lock in the cost basis method when I convert. I have a limited understanding of the ramifications of the three options：average costs, first in first out, and specific identification. Not sure what that is. Would this decision change my tax liabilities if I ever tax loss harvest or during drawdown phase? Thank you for all the great info. Brandon S. P.S. Try to find time to include a cousin Eddie sound bite, possibly regarding gerbils and plastic sheets. Well, as to that last comment, this is a family show, but perhaps I can come up with something.

Mostly Voices [21:42]

You surprised? Surprised, Eddie? If I woke up tomorrow with my head sewn to the carpet, I wouldn't be more surprised than I am right now.

Mostly Uncle Frank [21:51]

As to your other questions, first on the rebalancing, particularly when you're talking about equities, there isn't a whole lot of rebalancing usually that goes on. The easiest way to handle it in your accumulation phase is just to add more of the thing that's low. I don't know of any studies showing that you're better off or worse off without that. Really rebalancing makes more of a difference when you're talking about really uncorrelated assets or negatively correlated assets. When you have a bunch of equity funds and they're all positively correlated, rebalancing isn't going to do a whole lot. for them regardless, just by their nature. In terms of calendar rebalancing, I will link again to the Michael Kitces article about optimized rebalancing in the show notes. That's mostly for a retirement style fund, but it basically concludes that rebalancing on a calendar schedule that's less than a year It's probably not useful and it probably doesn't help you any. So a year is the minimum. There's been theoretical musings by Bill Bengen and others, including Paul Merriman, that, you know, maybe not rebalancing even in one year is a good idea that, it may be a longer period. The Kitses article does focus more on using percentage bands to rebalance. which may be a more optimal way overall because it's not dependent on a calendar, but it does take more work. Now, as for your ETFs versus mutual funds, yes, mutual funds still offer the auto investing in most places that ETFs don't. I have not taken a survey as to which brokerage is do which things which way. I know M1 does everything automatically, and that's one of their big selling points with their Pies and how they do that. And they use ETFs for that purpose. But honestly, it's really not that hard to buy ETFs on a monthly basis. You can do it on an app on your phone. It, you know, takes a few minutes a month to do. It's not as onerous or difficult as it might seem, and you're going to eventually be managing your assets anyway, so maybe it is time to get into the habit of that. If you want to stick with your mutual funds, that's fine too. You're going to be just fine regardless of which way you go about this. I don't know anything about how Vanguard does its conversions, and man's got to know his limitations. how it makes that not a taxable event, but I've heard that to be true as well. As to the options for the cost basis, okay, average cost is a convenient way if you're converting or selling a whole bunch of a mutual fund at one time and getting an average basis for it because it literally looks at all of your purchases. and since in mutual fund world, you could have hundreds of purchases, it's convenient way of just putting that all down into one thing, otherwise you have to look at each one of them and sometimes if you're reinvesting the dividends, for example, you're investing 10 bucks at a time or 5 bucks at a time and it really becomes annoying not to use an average cost basis for that. First in, first out is the typical default way that it's done that the oldest thing you have is sold the first. The reason that is set up as the default is because it's more likely to get you into a long-term capital gains situation than a short-term capital gains situation. The specific identification method is where you are picking a specific lot. So say you have some long-term holdings and they're profitable, but the ones you bought Six months ago, and there's been a downturn, and you want to tax loss harvest that, you can pick that specific lot and use that and say, I am selling that specific lot and tax loss harvest that. So in the aggregate, it doesn't matter that much, particularly if you're talking long-term capital gains, you're not going to sell this stuff for a long time anyway. It would only be if you're doing more manipulations before that. that it might matter. So I wouldn't worry about it too much, but at a certain point you're going to need to decide when you're going to become an ETF investor because that is really the way of the future and you will end up holding some of them eventually, even if you don't need any of them right now.

Mostly Voices [26:46]

What we do is if we need that extra push over the cliff, you know what we do? put it up to 11. Exactly.

Mostly Uncle Frank [26:53]

One of the reasons that we use ETFs in our sample portfolios and we use Fidelity in particular is that I can buy and sell them on my phone and they do fractional shares. So I can sell $30 worth of VTI without any trouble. You have a gambling problem. And I think that is the way Most brokerages are going to evolve too. Vanguard's a little bit behind on the technology type stuff, but hopefully they'll catch up and they'll be just as good as everybody else again in terms of ease of use.

Mostly Voices [27:38]

We can just transfer money from your account into a portfolio with your son and it's gone!

Mostly Uncle Frank [27:42]

In addition to having mostly the cheapest fund. But now I see our signal is beginning to fade. Wrong! If you have comments or questions for me, please send them to frank@riskparityradio.com that email is frank@riskparityradio.com or you can go to the website www.riskparityradio.com and fill out the contact form and I'll get your message that way. In our next episode, which will probably be on Thursday, we will be unveiling our seventh sample portfolio. I'll drive that tanker. Which should be fun. And then this weekend we'll have our weekly portfolio reviews and our monthly reviews of the distributions that we are taking out of those portfolios and we will have some emails, most likely. Cool. If you haven't had a chance to do it, please go to Apple Podcasts, wherever you get this, leave it a five-star review, follow it, like it, or do whatever you can do to support it there. That would be great. Okay. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Voices [29:01]

And it's through the candle that you will see the images into the crystal. There is intelligent life in the 11th galaxy on the planet NepTune, which will conquer Earth in the year 5482, utilizing us for slave labor and the Chelonian salt mines.

Mostly Mary [29:17]

The Risk Parity Radio Show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here making sure to take into account your own personal circumstances.