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 [0:37]

Thank you, Mary, and welcome to episode 116 of Risk Parity Radio. Today on Risk Parity Radio, we will be doing what we seem to do best around here.

Mostly Voices [0:49]

Here I go once again with the email.

Mostly Uncle Frank [0:57]

First off, we have an email from Ralph. And Ralph writes：hello.

Mostly Mary [1:01]

I just started listening to your podcast and decided to check out your site. It's very nice. Thank you for putting this all together. I've been a fan of the Golden Butterfly for years and coincidentally put together a test portfolio also. 40% FISVX, 20% FUMBX, 20% FNBGX, and 20% GLD. Some of your other portfolios are new to me, but I will be looking into them further. A couple of questions. How do you handle dividends, reinvest or into cash? If cash, do you pull as part of your monthly withdrawals? Also, do you have any thoughts on purchasing bonds versus bond funds? Thank you.

Mostly Uncle Frank [1:44]

Well, thank you for this. Yes, you do have a risk parity style portfolio. The only difference between you and the golden butterfly is that you have all of your stocks in small cap value as opposed to having them divided into small cap value and a total market fund or a large cap growth fund. As to your questions, how do we handle dividends? Well we are distributing from these portfolios so we take them in cash and then they sit there in cash and they eventually form part of a distribution in the next month or months subsequent to that. Groovy baby! If you were using your portfolio for accumulation, you would reinvest that cash. Either you could do it immediately or you could just collect it all and then reinvest it into whatever was low if that's the thing you were doing there. As to thoughts on purchasing bonds versus bond funds, Well, I suppose you could purchase bonds individually, but it's going to be a lot more work. And the difficulty you may run into is if you are trying to rebalance out of a bond, then you have to sell that bond. And it's not that easy to sell individual bonds. It's relatively easy to purchase Treasuries at treasurydirect.gov if you want to just hold them, but it's not as easy to sell them. So I think for our purposes we would prefer to stick with bond funds, particularly since we have specialized bond funds in the forms of ETFs and so we can really zoom in on which ones we actually want. For more episodes about bonds in particular, you might want to have a listen to episodes 14 16, 64, and 69 as to how these bond funds are constructed. Generally, they are constructed as small ladders inside them, depending on what they are, if they are specialized funds. So for instance, a short-term bond ladder or short-term bond fund, I should say, will have one, two, and three year bonds in it. And then when the one years roll off, they'll buy more three years. Similarly, a long-term bond fund may have up to 10 years of bonds of various durations and they will be selling the youngest one and buying the oldest one on an annual basis. This does create some capital gains or losses for some of these funds. You'll find they are most significant in things that are zero coupon or stripped type bonds. In particular, if you look at something like EDV, which is a Vanguard long duration bond fund, that often has substantial capital gains at the end of the year. And you'd want to be aware of that if you're going to invest in something like that. And thank you for that email. Second off, Second off, we have an email from Justin, Justin J, and Justin writes：hi

Mostly Mary [5:09]

Frank, my second question to you. Thanks for answering the other one about two months ago. Today's question：Is it just me, or does Portfolio Visualizer return way more pessimistic portfolio return assumptions than portfolio charts? I'll put in my portfolio a variation on the Golden Butterfly with a bit towards commodities and rates. and get back a perpetual withdrawal rate of 5.3%. Then go to Visualizer, plug in the same numbers to see their presentation of the data, especially the percentiles chart, and see that the 50th percentile interval there says 4.2% for the perpetual withdrawal rate. Even the 75th percentile is lower than 5.3, though the 90th is higher. If I fiddle with the portfolio a bit on both sides, I will still see a more negative outcome on Visualizer than on Charts. Seems like the 50th percentile on Visualizer should be right around the Charts verdict, no? Any insight on what's going on here? Am I misreading the data? Maybe Charts is posting the 80th percentile, but then why? Different tax assumptions? Different data sets? Is Visualizer defaulting to higher fee mutual funds and Charts is using lower fee ETFs, or maybe even the indices themselves? When you run the Monte Carlo simulation on Visualizer, it has all these drop-down buttons. Is there a way to configure it so that it matches whatever assumptions or parameters Charts is using? That might help me figure out the discrepancies. Thanks and keep up the good work.

Mostly Uncle Frank [6:47]

I speak for everyone out here in RP Radio Land who benefits so much from your willingness to share what you know. Justin. All right, let's see if I can answer your questions generally. I think the answers might be different depending on what exactly you're analyzing. Typically though, at portfolio charts, they are looking at one 50-year time frame that they have set up, and that's done on an annual basis. It goes back to 1970. If you go to Portfolio Visualizer, you'll find that the data sets don't often go back that far. They usually go back to sometime in the 90s if you're looking at asset classes or to the life of a fund, which could be a lot less. If you're looking at something like that, the furthest they seem to go back is to about 1973 with respect to some of their funds. So you are going to get some differences depending on which data set that you use for that. The other difference you might see is if you set Portfolio Visualizer to monthlies, it will look at monthly data and analyze that. Or you could leave it at annual and it will analyze it on an annual basis. I usually try to use monthly when it's available. Portfolio charts does not have a monthly feature, so it is on an annual basis the whole time. And so you may see some differences there. Where you may notice these differences is in particular in a portfolio like the Golden Butterfly, because there was a very sharp increase in the price of gold early in the 1970s that is not always picked up by portfolio visualizer. And so if you have a more gold heavy portfolio, it's going to look better at portfolio charts than it will typically at Portfolio Visualizer. At least that's what I've seen. So what I always try to do as best I can is to use both. If you're serious about using a particular portfolio, particularly because you know that Portfolio Visualizer is not going to capture much of that inflationary era of the 1970s that may be picked up better by portfolio charts. Portfolio charts, of course, does not have as many different asset classes or individual funds you can pick from, but you can get a general idea if you pick something similar to that. And if you are interested in the gold episodes in particular, those would be episodes 1240 and 83. And you can easily find particular episodes about particular kinds of investments if you go to the little index on the podcast page at www.riskparityradio.com. There's a little index there of the things that we've analyzed specifically. And so you can go back and listen to those depending on what you're thinking about or looking at. That would be great. Okay. So hopefully that answers your question as best as I can answer it. And thank you for that email. Our next email is from Ricky.

Mostly Mary [9:52]

Hey Frank, I had another question. Does risk parity take into account dynamic correlation changes under varying economic factors? I am seriously considering using long-term treasuries to act as ballast to my equities in retirement. I wanted to be as simple as possible and have my bonds all in TLT, but the following article shows a model where correlations to stock bonds can swing dramatically under different inflationary, interest rate, and volatility environments. Does risk parity take this into account? Is this why I can't do 60/40 with 40% bonds being TLT, or heck, just all bonds in general? Thanks, Ricky.

Mostly Uncle Frank [10:35]

All right, let's talk about this article which I will link to in the show notes. This is an article from PIMCO, it is Quantitative Research from November of 2013 about stock bond correlations. Now what the subject of this article was in particular was trying to figure out whether there's some correlation between the rate of inflation and then the correlation between stocks and bonds. And they found various things at various times. But what you should get out of this is what they're really not talking about here, although they do acknowledge. And that is this. During Flight to Safety episodes, we observe the familiar negative correlation of stocks and treasury bonds. Yes. And why is that particularly important? This is on the first bullet on the first page. That is particularly important because in a sense, you don't care very much if your treasury bonds are acting in a correlated way to your stocks if they're both going up in value. Don't be saucy with me, Bernays. That's not your problem scenario. Your problem scenario is when your stocks are going down and then you want your treasury bonds to rise in value. And this paper acknowledges that that is a typical behavior, and you can see this in a few places, although it's not really the topic of this paper. They cite some previous research from 2004, where it was found that when the implied volatility, as measured by the CBOE volatility index, or VIX, is high, stock and treasury returns become more negatively correlated. Cool. What does that mean? Well, when you see a high VIX, that's typically during a stock market crash. And so when the stock market is crashing and the VIX is high, the correlation with treasury bonds is more negative, which is exactly what you want when the stock market is crashing because then your treasury bonds will increase in value.

Mostly Voices [12:44]

You are correct, sir.

Mostly Uncle Frank [12:47]

And the paper goes on in great detail to discuss a method of analysis and they come to a conclusion that when inflation rates are particularly high, oftentimes you'll see treasury bonds and stock market correlations or positive correlations then. But you have to put that in context because as they say in the penultimate paragraph of their paper, lastly, our framework is not meant to be a substitute for forward-looking investment process. While our model assumes linear relationships, the flight to safety effect during extremely negative growth shocks may overwhelm any other effect and produce a negative correlation between stocks and treasuries despite inflation shocks. Real wrath of God type stuff. And so what they're saying is that the effect they're describing here is not significant when you compare it to what happens in stock market crashes. This is also reflected in figure number one on page three of this paper, which is interesting to look at 'Cause what it is showing is a kind of a year, two year by two year correlation between stocks and treasuries. And what you see here is every time the stock market crashes, the correlation goes negative and deeply negative. And so it did that in the 1929 crash, you see it around 1969, you see it in'73-'74, you see it in'87, you see it in'99, you see it in 2008. And that's despite there being positive correlations in many of the years in between. And this is illustrating what I just read from the paper, that this effect, stock market crashes, induced negative correlations with treasuries due to the flight to safety aspect of them. And that's why you have those negative correlations precisely when you need them the most. and that is ultimately what feeds into why they are something you want to put in a risk parity style portfolio, which will reduce the volatility or the overall volatility of the portfolio due to the negative correlations and consequently raise the projected safe withdrawal rate for the portfolio. What I always find most interesting about these kinds of articles though is when they were written and what they predicted afterwards, because we know what that is now. So we know whether it's predictive, whether it's a good model or not, whether their crystal ball is even worth looking at.

Mostly Voices [15:19]

A really big one here, which is huge.

Mostly Uncle Frank [15:22]

And what they say at the beginning is there may be rising inflation in the future that would make the correlations less negative or perhaps positive. If this happens, perhaps traditional paradigms may shift. Forget about it. Then after that it says, under their central scenario, the correlation is not expected to rise above 0%, even over a two-year time horizon, which would have been 2014 and 2015. And in fact, what we saw in the future history is that the correlations remained largely negative since 2013. But more importantly, when the stock market crashed in 2020, We saw that spike of negative correlations where the long-term treasury bonds went up 25 or 30% during March 2020, exactly when you needed them to ameliorate the effects of the stock crash. Yeah, baby, yeah! So in effect, what has been occurring in the past since 1929 has continued to hold true. You can't handle the truth. And you would have to say then that the speculation that it's not going to hold true in the future is not based on any data. It's based on a narrative and a crystal ball. So I know people like to say that, but... My name's Sonia.

Mostly Mary [16:50]

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

Mostly Uncle Frank [16:58]

They've got to show something in terms of data as to when and how this could happen. Because the data that we just looked at and is in that paper and the other papers that cited, just say that's not the way it works. That's not how it works.

Mostly Voices [17:08]

That's not how any of this works.

Mostly Uncle Frank [17:12]

So now going to your question, does risk parity take into account other environments? And is this why I can't just do 60/40 with the 40% bonds just being TLT or heck just all bonds in general? Well, what we learned from that paper is that there is a specific pronounced effect during high volatility regimes and stock market crashes where treasury bonds are the most negatively correlated. And so risk parity does account for that. It basically says, Look, we want things that are going to move in opposite directions when we need them to do that most, particularly in a portfolio that is primarily driven by stock returns. And so that is accounted for. As for how does a risk parity portfolio account for inflation, that is done by putting things in the portfolio that do well in inflationary environments. which would include gold, small cap value stocks, REITs, commodities, those sorts of things. So yes, it's accounted for, however, not with respect to the bonds. Now, as to why you wouldn't want to have 40% bonds, well, the reason you use the long-term treasury bonds as opposed to the intermediate or short-term treasury bonds is so you don't have to have as many. If you wanted to have the same kind of effect with intermediate term treasury bonds, then you probably would have to have 40% of the portfolio being those. And it would then look kind of like those portfolios analyzed by Bill Bengen or the Trinity study back in the 1990s, which were based on bond portfolios that were solidly and completely intermediate treasury bonds. What you can do though is knowing that the long-term treasury bonds are more volatile, you just don't need as many. So you can cut that percentage down and then add other things into your portfolio to make it even more diversified. As for why you wouldn't just use bonds in general or all other bonds, as a matter of fact, many bonds are positively correlated with the stock market during stock market crashes, and that includes generally all corporate bonds and international bonds. And so if you go and look at what happened to those during the crash in March of 2020, or most recent example, those did go go down in value when the stock market went down. They did not exhibit the same characteristics as the treasury bonds, which is why you really don't want those in a portfolio that is primarily based on returns coming from stocks, because they're not helping you on the diversification side. And if you want to hear more about that, I would go back and listen to those bond episodes, particularly episodes 14 and 16, where we talked about all the different kinds of bonds and how they went well or did not go well in a risk parity style portfolio. But thank you very much for this email and the article because it reinforces what we've been saying here. Yes! It's always good to know that the academics agree with you.

Mostly Voices [20:28]

You need somebody watching your back at all times! Ricky don't lose that number. Ricky don't lose that number. Ricky don't lose that number. And our next email comes from Dan.

Mostly Uncle Frank [20:44]

And Dan writes, Hey Frank, we've interacted

Mostly Mary [20:48]

just a couple times online in the Choosefi group, but since Choosefi released the more recent podcast with Portfolios, I've been listening to your podcast more. I'm reaching out because the more I've been listening to your podcast, the more I'm realizing we're taking similar approach to investing, though we're emphasizing different timeframes of the investing horizon, accumulation versus decumulation. I have the blog Keep Investing Simple, Stupid, and what I've come to realize is that my take on accumulation is essentially a risk parity approach to the stock allocation by incorporating the academic research on factor investing. I am reaching out because I think we could have a great discussion on the application of a risk parity approach that I'm sure would generate lots of questions and discussions among your listeners. From listening to your podcast, you sound pretty familiar with factors. I know you listen to Ben Felix too, huge fan, and I think I could add some to that discussion too. Let me know if you'd ever be interested in collaborating on something. Anyway, I've enjoyed the podcast and definitely appreciate the emphasis on something other than what I would call the VTSAx and chill approach that used to dominate the FI world.

Mostly Uncle Frank [21:59]

Yes, I think you are correct that we are scratching at the same post, if you will, in terms of trying to find things that are uncorrelated or have lower correlations than other combinations, which therefore should perform a bit better. I think the problem you always have with combining stock funds is simply that they're very highly positively correlated as a general matter. And so you get to what it says in the book of Jack, Common Sense Investing by Jack Bogle in chapters 18 and 19. that ultimately your portfolio is going to be driven largely by the macro allocations, the stocks, the bonds, the other, as opposed to what's within each component of that. That being said, there's always room to improve in terms of just getting better accumulation portfolios or improving on the mix in your stock portfolio, particularly dealing with stocks that do well in low inflationary environments and stocks that do better in higher inflationary environments. And I think that is really important to get down and make sure that you have in place in your risk parity style portfolio, which goes against the idea that VTSAX and CHIL is the best idea for a drawdown portfolio because those large cap growth stocks probably will not do well in inflationary environments, at least historically they have not done so well. If you go back to the nifty 50 of the 1970s, whereas if you own small cap value stocks that invest in things like insurance and commodities, you're going to get better performance out of stuff like that. And I would be very happy to do some kind of collaboration However, you must know that I am retired and therefore I am lazy. And so if you want to create a podcast, you'll need to create that and I will appear on your podcast or contribute in some other way.

Mostly Voices [24:05]

I'm funny how? I mean funny like I'm a clown? I amuse you? I make you laugh?

Mostly Uncle Frank [24:09]

I am just a mere hobbyist with my microphone and easy chair. Ain't nothing wrong with that.

Mostly Voices [24:16]

And as an interesting note, we did cite to your podcast,

Mostly Uncle Frank [24:19]

I'm sorry, your blog back in episode 16, which was about those treasury bonds and how you had incorporated them into your portfolios. And you also had something called the Swanson portfolio that we cited to there. And so, anybody wants to check it out, go to the podcast page, go to episode 16. And you will see the links to the Keep Investing Simple, Stupid blog. And thank you for that email. These go to 11. And our next email comes from Anderson.

Mostly Mary [24:58]

And Anderson writes, Frank, I'd be interested in knowing your thoughts on the hedge fundy risk parity style portfolio. I see it popping up in lots of places.

Mostly Uncle Frank [25:06]

What do you think? So yes, we have talked about this hedge fundy, Portfolio. We talked about it in detail in episodes 82 and 110, and I would go back and listen to that because we talked about an analysis I did if you were to take that back to 1970. One of the problems you see is that the analyses that are commonly available only go back to the 80s or not even that far. If you took this kind of portfolio, which is only S&P 500 and long-term treasuries. It would have struggled in the 1970s. It would have had a drawdown of 69%, which is probably not acceptable to most people. It had a safe withdrawal rate over 50 years, only about 5.7%, which is not good enough for a leveraged portfolio, I would say. What it's really missing is what we've been talking about. It should have some small cap value stocks in there. It should have some gold in there. It should have some components in there that would deal better with an inflationary environment. But it is a leveraged portfolio with three times leverage, so it's going to have big swings and make big profits when it's doing well. It is most similar to our aggressive 50/50 sample portfolio, if you want to take a look at that, which is not as aggressive as that portfolio, but it's the same idea. If you look at the accelerated permanent portfolio that's Another sample portfolio that also has some of these leveraged funds in it, but is even less aggressive, that is closer to something that would do well in all kinds of environments. Although I would add some small cap value to that if you were going to use it. If you want to check out another experimental portfolio that I constructed for the Choose FI people and they have over and their M1 listing, you can go look at that. And that would probably be something more along the lines of something that would not have really excessive drawdowns and would still do very well in many environments. Well, thank you for that email and your suggestions. But now, last off.

Mostly Mary [27:28]

Last off, we have an email from Phil and Phil writes, Dear Frank, I'd like to thank you for your comprehensive response to my email on your show. The comments were extremely helpful. Best regards, Philip. Well, I'm very glad to be helpful.

Mostly Uncle Frank [27:39]

That's why I like to share this information. I find all this stuff very interesting and it's nice to know that at least a few other people also find it interesting and like to talk more about it. If you are looking for Phil's question and response that's back in episode 87. He is a UK national based in the Middle East and so had some interesting issues to raise. And thank you for that email. But now I see our signal is beginning to fade. Shut it up, you. We will be picking up this weekend with our weekly portfolio reviews of the seven sample portfolios that you can find at www.riskparriyradio.com and we'll probably address a few more emails. We are working our way through August now and if you've sent one in the past two or three weeks we will be getting to it presently. If you have comments or questions please send them to frank@riskparriyradio. com that email is frank@riskparriyradio.com or you can go to the website www.riskparadioradio.com and fill out the contact form and I'll get your message that way. If you haven't had a chance to do it, please go to Apple Podcasts where you pick this up and like it, subscribe it, give us some stars and all that good stuff. That would be great. Thank you once again for tuning in.

Mostly Mary [29:16]

This is Frank Vasquez with Risk Parity Radio. Signing off. 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.