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 Risk Parity Radio. If you are new here and wonder what we are talking about, you may wish to go back and listen to some of the first episodes where we did our introductions of the various topics. And those episodes are episode one, 3, 5, 7, and 9. And so if you go back and listen to those, it will get you up to speed. Today on Risk Parity Radio, we have a little treat for you. At least I hope it's a treat. Surely you can't be serious. I am serious. And don't call me Shirley. One of our listeners, Alexei, who I think is a relatively recent newcomer to the show, Sent me an email last month and became a patron on Patreon, which you can do from the support page at www.riskparityradio.com, and then your emails go to the front of the list. But now Alexei got a little bit excited and sent me about eight more emails. So we can't just make this the Alexei show, not every week or every Episode. But I thought what I would do is bring Alexei in here figuratively and go through some of these emails because I think they raise a lot of interesting and theoretical questions that others may have about risk parity style investing.

Mostly Voices [2:03]

Yes.

Mostly Uncle Frank [2:07]

So without further ado, why don't you just come in here and pull up a figurative easy chair, Alexei. And we'll see what Uncle Frank can do for you today. Mr.

Mostly Voices [2:18]

Howell, now that I'm a member of the club, what can I do? I had more fun as a club steward. Well, you haven't got the knack of being idly rich. You see, you should do like me, just snooze and dream.

Mostly Uncle Frank [2:28]

Dream and snooze. The pleasures are unlimited.

Mostly Mary [2:32]

So, what is the first topic on your mind? Dear Frank, first off, thank you so much for answering my first email. I'm a little embarrassed at how excited I was to hear that episode. It was similar to the feeling I had when I met Dusty Baker at a produce shop in Chicago when my beloved giants were in town for a series at Wrigley. 2. Apologies for previously calling UGL a three times leveraged fund when it is actually two times leveraged. 3. After writing the above email, I heard the episode in which you and a listener introduced Gold as an older substitute for GLD in long-term back tests on Portfolio Visualizer. After this revelation and further backtesting, it seems that 15% gold truly is the sweet spot for risk return in a risk parity portfolio. This is particularly true when safe withdrawal rates are calculated back to the 70s using portfolio charts. I now favor 7-8% UGL or 15% GLDM as my gold allocation. As an unexpected benefit, This extra slug of gold seems to help portfolios achieve similar downside protection with only 15% short-term Treasuries as opposed to 20%. On a similar note to the gold substitution, DFSVX is a good fund for long-term backtesting of small value. Four, one merit to consider for using UGL over GLDM or GLD is that in taxable accounts it is taxed as an options fund. Capital gains 15% long term, 35% short term, as opposed to taxed as a collectible 28% to 35%. Five, your discussion of the Seeking Alpha article on TYD as a TLT substitute in risk parity portfolios was very interesting. Until they come up with a six times leveraged intermediate treasury fund, however, TMF will remain my horse, as three times long Treasuries still seem to kick three times intermediate Treasuries risk return but in the backtest of leveraged risk parity portfolios. Six, in taxable accounts, replacing 50% of my short-term Treasuries bucket with a long-term taxable municipal bond fund like TFI seems to juice the returns a bit without significantly increasing overall volatility. Thoughts? Given the above observations, here is the current makeup of my model risk parity portfolios. Aggressively aggressive portfolio：29% UPRO, 28% TMF, 15% SHY, 8% UGL, 10% XLU, 10% REIT, 2% each of DLR, PSA, CCL, AMT, and O. Comfy Aggressive Portfolio：20% UPRO, 20% TMF, 15% SHY, 10% XLU, 10% VCLT, 10% REIT, 7% UGL, 8% PFF, Aggressive for Taxable Portfolio：30% UPRO, 30% TMF, 10% UGL, 10% SHY, 10% TFI, 10% XLU. Seven, final point. I continue to love the sound drops. They truly are one louder. These go to 11. Did you know there are a lot of great lines in the Big Lebowski? Just saying, regards Alexei.

Mostly Uncle Frank [6:15]

All right, let's see if we can address a few of these things. That would be great. First of all, yes, your observation that 15% gold seems to be kind of a sweet spot for the use of gold in a portfolio, at least a drawdown portfolio, I think is correct. And if you go back and I believe it was episode 40, I will link to it in the show notes, and an article from Early Retirement Now, where being Erm McCracken went back a hundred years and analyzed golden portfolios in his Safe Withdrawal Rate Series Number 34, and he determined that 15% seemed to be about the sweet spot as well. So this fact from the data has come up over and over again and seems to be more firmly established that that is about the right amount. I also linked to an article just a few episodes ago about three ingredients for portfolios like this. from Tyler over at Portfolio Charts, which came to similar conclusions. And I'll link to that again in the show notes. I have not personally used that leveraged gold fund, UGL. I had experimented with some of other funds a few years ago and they didn't work out so well, but maybe that one's a bit better. It seems to have caught on these days like UPRO and TMF. Now, as to TFI, that municipal bond fund, I took a look at that. I don't think it's worth it to use something like that. And the reason is simply this, that if you look at stock market crash scenarios, that seems to crash with the stock market and doesn't give you a whole lot of return when it's not crashing. To me, it reminds me a bit of TIPS. So I think you're not getting a whole lot of return and it is adding a risk to the portfolio that may not be worth it. Of course, in good times it will work a little better than a short-term bond fund for sure. Now, as for your proposed portfolio constructions, I did not go back and test all of these things, but I think you're getting the hang of it. I think you're getting the idea of how you might construct portfolios with this, which is hopefully what people are getting out of this podcast, at least the more adventurous ones that the sample portfolios are indeed sample portfolios and I do not intend them to be the be all and end all of these kinds of portfolios. I think there's a couple of basic things you need to keep in mind when constructing portfolios, though, generally. In addition to this holy grail principle, where you're trying to get these uncorrelated assets into a portfolio so they can work together. You also need to be mindful of the macro allocation principle and the simplicity principle. The macro allocation principle in this context says that if you're looking at the macro allocations of, say, stocks to treasury bonds to gold to other things, every portfolio that has the same basic macro allocation is going to perform pretty similarly to another portfolio that has that same basic macro allocation. So you can end up with a lot of things that perform similarly and cannot say in the future which one will be better than the other one. because they are likely to perform 90% the same or more in the future if they have the same macro allocations. And then we also need to keep in mind the simplicity principle. The more complex you make a portfolio and the more fitted it is to pass data, the less likely it is to perform the same way in the future. That is what we call the bias variance dilemma. A portfolio that only relies on a few funds and a few rules, and assuming these funds are broad-based index funds in whatever category they're in, that portfolio is more likely to perform as it has in the past than a portfolio with lots of different funds in it and lots of bells and whistles. So you should always have a basic preference for a simpler portfolio over a more complex portfolio and need to have good reason to depart from that. I think a lot of the commercially prepared global portfolios, some of them risk parity style, some not, tend to fall into this trap. They just put too many things into a portfolio and hope it's going to work. It usually doesn't work out the way it did in the past. And it becomes a real temptation. So you have to know your limitations. Man's got to know his limitations. Now, as to the big Lebowski, there's a lot of unusable material in that film, but maybe there'll be a couple of things we might be able to use here. I am not Uncle Frank. You're Uncle Frank. I'm the Alexi.

Mostly Voices [11:14]

So that's what you call me, you know, that or his dudeness or, Duder or, you know, Bruce Dickinson, if you're not into the whole brevity thing.

Mostly Uncle Frank [11:26]

All right, what else is on your mind?

Mostly Mary [11:29]

Dear Frank, I may have a gambling problem.

Mostly Voices [11:33]

You can't handle the gambling problem.

Mostly Mary [11:37]

The concept of leverage in a risk parity style portfolio may prove too enticing to me. I'll show them.

Mostly Voices [11:41]

I'll show them all.

Mostly Mary [11:45]

I simply love the idea of leveraging up risk parity portfolios for two main reasons. One, the obvious reason, it allows me to pursue the free lunch of true portfolio diversification while still pursuing stock-like, better risk-adjusted returns. Two, the less obvious reason, using levered funds opens up valuable space in the portfolio for new additive and orthogonal investments, which adds the possibility of even more diversification within the portfolio, without diminishing the main driver of the portfolio return, stock allocation, or the main source of crisis insurance, treasuries. In practice, I am moderating my attraction to leverage by leaving most of my tax-deferred 401 money allocated to plain old equity index funds. But I am transitioning my taxable accounts and side hustle 401 money to the leveraged risk parity style portfolios I previously mentioned. I call these portfolios Nitro Portfolios because they are super powered, fast, and perhaps more than a little bit dangerous. Danger, Will Robinson. Danger. Danger. To that point, there seems to be the possibility of unique and to date unanswered questions about the suitability of levered ETFs for a long-term buy and hold DIY investor. I see the main risks questions for these funds as the following. One, there are unanswered questions about these funds' behavior in crisis. Particularly, could these funds be at risk for total failure liquidation with certain Black Swan events by virtue of their leverage? As an example, what happens if there is a Black Friday style stock market crash where the market drops 35% in a day? The truth is we don't know. We've never seen how these funds behave in such an environment. the known unknown. Two, given the lack of history for these funds, might there be other unique risks to using these vehicles or unexpected effects to their inclusion on overall portfolio behavior volatility that we haven't even considered? The unknown unknowns. Which got me to thinking, is there a way of harnessing the Nitro Return Supercharging Profile of leveraged ETFs without overexposing oneself to catastrophic portfolio failure in the event that one or more of these funds fails? Is it possible to take a risk parity portfolio to 10.5 without resorting to going to 11? Push over the cliff. Is it possible to turbocharge an existing portfolio without going full nitro? In there's 7,000 horsepower, nitro burning suicide machines. Could such a portfolio even be considered by someone in the withdrawal phase as opposed to someone like me in the accumulation phase? I came up with the following rules for this exercise. One, no more than 25% of the total portfolio allocation may be devoted to leveraged funds. The thinking here is that even in a worst case scenario, total failure of all your uncorrelated leveraged funds, the investor would still be left with a risk parity portfolio worth roughly 75% of its pre-failure unleveraged value. Two, no single macro ingredient, stocks, bonds, gold, rates, commodities, et cetera, would be allowed to be comprised of more than 50% leveraged funds. The thinking here is that no one macro component should be allowed to disappear because of a leveraged ETF-specific risk. So what do you say, Frank? Would this be a reasonable approach to take in retirement? Would the additional risk be worth it for the additional expected returns? Would a retiree holding this portfolio be able to survive the unlikely doomsday scenario of the simultaneous and total destruction of his leveraged ETF holdings?

Mostly Uncle Frank [15:44]

Regards, Alexei. Well, I appreciate your enthusiasm, and I'm hoping that we can as do-it-yourself investors make some use out of the possibilities of leverage in these portfolios going forward. But as you point out, there are risk to this kind of a strategy, and a lot of it has to do with these funds not having been around that long. So we have not seen, for instance, a 1987 style crash to see what that would do to something like UPRO. We just haven't seen it. What happened in March 2020 was a good test for these portfolios, I should say these funds, and we did see You know, UPRO go down proportionally as TMF went up. And that is honestly the main solution for most of these things. If you're going to have something with leverage on one side of an equation, put something that's negatively correlated with leverage on the other side of it to balance it out. As to your second point here, yes, there are unique risks to these kinds of funds outside of Market risks, and one of them happens to be what is called counterparty risk. A lot of these leveraged funds are built on what are called swaps contracts, and they are basically a contract with a usually a large financial institution, and usually the fund will have up to 10 different financial institutions they're signing these contracts with. And those contracts, a swap contract is basically just a bet on an index. If the index goes up, then the financial institution has to pay the fund. If the index goes down, then the financial institution gets money from the fund. It doesn't work quite that simply, but that's the idea. In any event, there is a risk that whomever is on the other side of this contract would not be able to perform. It's probably a pretty small risk considering the nature of these banks and how connected they are with the global financial system, but it is a risk. The other risk for some of these products has to do with the options or futures that are in them, which may not perform exactly like their markets and may have some kind of role problem to them. I've noticed that more recent leveraged products are trying to get away, for the most part, from a lot of these futures and options things that require role. because rolling those contracts just creates a natural drag on the whole thing. You can see a good example of this in that new futures ETF for Bitcoin, BITO. You can see already that that is underperforming and has a serious problem in that they keep needing to roll the futures contracts, which puts a drag on the whole fund. And those sorts of funds are definitely undesirable and you want to stay away from them. Now you also asked if there were other ways of taking leverage or of moderating the leverage. And the answer, of course, is yes. You can simply make the leverage funds a much smaller proportion of the portfolio and adjust the leverage that way. The other way to do this would be to take a more standard unleveraged portfolio, put it in a margin account, and lever it up that way, take some margin on it. Of course, that's going to be more complicated to manage. And depending on where you go, the margin rates might not be very attractive. So that entails another set of risks. Now, about your proposed rules of thumb. No more than 25% of the total portfolio devoted to leverage funds. No single macro ingredient be allowed to comprise more than 50% of the leverage funds. Those seem to make sense to me as a general matter. This is an interesting topic because we have fund managers wrestling with this right now as to what is the optimal leverage for a leveraged kind of portfolio. If you go back and listen to episode 129 and look at the links in the show notes there, you'll see an interview that Meb Faber did of the people at Resolve Asset Management. I'm also going to link to one of their papers in the show notes, and you can download that if you want to look at it. But this is basically what it says. They did a study looking at different levels of leverage in these kinds of portfolios. They call their system return stacking, but it's basically risk parity. And what they determined is that it seems like the optimal amount of leverage from an efficient frontier perspective, which is the theoretical perspective, is about 1.6 to 1. And I won't go into the details of that, but I do wish to observe that that ratio is the golden ratio. That was weird, wild stuff. And I always guessed that something like that might be true, but I thought their paper was interesting to kind of confirm my suspicions on that. They also observed, and they linked to another paper called Buffet's Alpha, which observes that Warren Buffett in Berkshire Hathaway actually incorporates leverage the way they use their insurance companies and the float they get from those. And the amount of leverage calculated in this paper, which is a separate paper I'll link to in the show notes, is about 1.7 to 1. And they cite that as potentially further evidence that that is kind of the efficient frontier for using leverage in a diversified portfolio. Groovy baby! I've not included your additional sample portfolios, but I had the same comments that I had for the prior ones with the added observations about leverage just now. But in answer to your specific end questions, would a retiree holding a leveraged portfolio be able to survive the unlikely doomsday scenario of the simultaneous and total destruction of his leveraged ETF holdings?

Mostly Voices [22:01]

Human sacrifice, dogs and cats living together, mass hysteria.

Mostly Uncle Frank [22:07]

And I would say in theory, yes, because only part of them is going to be destroyed and the other ones are still going to be there. But at this point in the history of these sorts of things, I wouldn't bet the farm on it.

Mostly Voices [22:18]

Forget about it.

Mostly Uncle Frank [22:22]

If you're in retirement, you do need to remember what the purpose of your portfolio is, and it's to help you live in retirement. not to beat some benchmark. So if you don't need to take excessive risks, then I would advise you not take them. You might take the risk with something that you would plan to leave behind anyway, because then you won't feel bad if something bad happens to it, or you won't feel as bad.

Mostly Voices [22:47]

Do you think anybody wants a roundhouse kick to the face while I'm wearing these bad boys? Forget about it.

Mostly Uncle Frank [22:53]

All right, Alexei, what else you got for old Uncle Frank?

Mostly Mary [22:57]

Dear Frank, when choosing an index fund, I do believe that the cheapest fund is usually the best option, assuming sufficient size liquidity to allow us do-it-yourself investors to trade rebalance with minimal friction. But when choosing a factor-based fund, it makes sense to me that we should choose the fund that gives us the most concentrated exposure to the factor we are betting on. Assuming it's not too expensive illiquid. When using the fund factor regression tool at Portfolio Visualizer to find the smallest value ETF that has been around for 10 years or greater, I find that RZV is the obvious choice in this category. As an example, it is far smaller and valuery than VIoV. As a result, it is also less correlated to SPY. After this exercise, though my favorite small value fund isn't RZV, it's XSVM. Even though it is not as small or value-y as RZV, it has one additional factor that makes it my choice：a slight but non-negative exposure to the fourth Fama-French factor, momentum. As a side benefit, it is also slightly less volatile. I think this is a good thing from a risk parity perspective since all SCV funds are still quite correlated to the stock indices in general. Fair conclusion or is this a clear violation of the simplicity principle? Regards, Alexei.

Mostly Voices [24:30]

You can't handle the crystal ball.

Mostly Uncle Frank [24:33]

All right, if you look at different funds in the same category, yes, they will perform differently over different periods of time. It's hard to say with these small cap value funds how they will ultimately perform against each other because most of them just have not been around that long. Most of the past 10 years in particular has been a bad environment for these kinds of funds. It's a much better environment now. It was a much better environment in the early 2000s and it certainly was the best environment in the late 70s and early 80s. But I would not discourage anyone from choosing the kind of fund they want in any particular category. I've constructed those sample portfolios on our Portfolios page to just take basic generic funds in each category because I didn't want the focus to be on the selection of the funds. I wanted the focus to be on the principles involved and the macro allocations involved. to each asset class and sub asset class. Basically, I want it to be showing a performance of a generic portfolio that you could improve upon by picking different funds. But there is a caveat here. Whenever you're talking about choosing one fund over another, you can pick the one you want, but you need to avoid changing horses in midstream. if this fund does not appear to be performing as well as other funds. The danger here really is picking a fund, then seeing it perform not as well as some other fund in the category and saying, oh, I better switch horses. And you're doing it basically, you're selling low to buy a higher fund. And that is exactly how amateur investors tend to underperform the funds they hold. They keep looking at what's performed well recently and jumping into it and then it has an underperformance because there is a reversion to the mean going on here with these kinds of funds that are all in the same category. So pick the one you like, but you need to be committed to sticking with it over a long period of time and not switching out of it when it's at a low point. You could switch out of it when it's at a high point, but not at a low point. And now, young Padawan learner, you will find that it is you who are mistaken about a great many things.

Mostly Mary [27:06]

I understand you've been fiddling around with the pies over at M1. What's going on over there? Frank, I just wanted to share my experience with M1 with you. and your listeners should you so choose. M1 looked like the ideal robo platform to me. Automated trading, fractional shares, customizable portfolios, easy to track and rebalance, all terrific features. Eager to try the product, I transferred in $1,000 and allocated the money to a risk parity style portfolio. Once the money was invested in the account, it instantaneously lost over 1% in value. Looking at the trade confirmation in real time, I spotted the problem. My small order of FMF was purchased at a price of $51.59 per share, despite its trading range on the day of the transaction being $46.60 to $47.18. I immediately informed M1 of the issue and corresponded with them over two weeks waiting for an answer. Their final answer was that the bidask spread was $8 on the day of the trade. BidAsk is generally published at $0.05 to $0.50 even on slow trading days for this security. They declined to provide proof of their claim. I have no idea if this was simple incompetence in order execution or something far more nefarious like M1 selling order flow to other parties to allow in order for their own clients' orders to be front run for profit. What I am certain of is that this issue can be totally avoided on other platforms like Schwab, Fidelity, Vanguard, or even the much maligned Robinhood by simply placing limit orders for all transactions. Buy or beware, AZ.

Mostly Uncle Frank [28:55]

All right, I think this experience has revealed a drawback or potential drawback to the system they use over at M1, which is to create a pie of ETFs and then trade them at a particular time at the market price during the day when they process them. The problem you have here is that this fund FMF is extremely thinly traded. It only trades a few thousand shares a day. And that is a fund you would not want to use in M1's system. It might be a tumor. Because that is a fund that you need to put in limit orders to make sure you're not having the experience you just had with a very large bid ask spread. It's not a tumor. It's not a tumor at all. If you are using ETFs that are very liquid, you are much less likely to have a problem like this. But I am sorry for hearing that you had this problem. You need somebody watching your back at all times. Hopefully you will not have another problem like it. I do not personally have any accounts at M1. I find the concept interesting, but I've already got my accounts elsewhere. and don't mind doing the manual trading with the limit orders as I was trained in my youth.

Mostly Mary [30:22]

Bow to your sensei! But moving on, what else would you like to talk about today? Dear Frank, first off, I am truly sorry that I am inundating you with emails. As you may have guessed, I have been thinking a lot about risk parity concepts lately and enjoying every minute of it. Writing these questions helps me to crystallize my current thoughts and move on to my next question to ponder. Each thought exercise is a bit like hearing a song on the radio, liking it, and having to listen to it over and over again until you are sick of it. For me, understanding risk parity portfolios is an itch that simply must be scratched repeatedly.

Mostly Voices [31:01]

I don't think it means what you think it means.

Mostly Mary [31:05]

I am working on the assumption that as a happy retiree, you will feel no pressure to respond to any of my emails. Oh, I didn't know you were doing one. If it's too much, say the word and I'll cool it in journal or something, but in case it's not too much. I make you laugh.

Mostly Voices [31:19]

I'm here to amuse you.

Mostly Mary [31:23]

Today, I have been struggling with my own competing impulses to pursue a true risk parity a la Ray Dalio and the impulse to stick to a more conventional equity risk dominated 60/40 style approach. As I understand it, the idea of true risk parity is to diversify across economic regimes, preferably by using uncorrelated or non-correlated asset classes with positive expected returns. Furthermore, as I understand it, in risk parity style portfolio design, leverage is used to equalize standard deviation risk among uncorrelated or negatively correlated assets by leveraging up less risky assets like Treasuries to equalize their risk exposure to that of more volatile assets like stocks. In theory, this spreads risk across both distinct economic regimes and macro asset allocations. There's a beautiful simplicity to this approach, but the road seems to lead to a very unconventional portfolio with relatively little stock exposure and lots of exposure to bonds and alternatives like gold and commodities. As for the 60/40 portfolio, it's the benchmark that seems to have lived within all investors' minds for at least the last 50 years. Sure, it ends up being very asymmetrical with all of the risk reward concentrated on the stock side and bigger danger zones threatening at all times, i.e. the infamous inflationary recession quadrant. But for the whole time I've actively followed the market, about 15 years now, This old warhorse's obituaries were being written on a yearly basis, and it's continued to do damned well. Furthermore, when I am designing portfolios, it's like I can feel the 60-40s influence pushing me to always add a little more equity exposure. I couldn't help but notice that your Golden Ratio portfolio also has close to a 3：2 ratio of stocks to bonds, and while the REITs only pushed the total stock amount to 52%, that's a pretty stock forward risk parity style portfolio. Could this be the invisible hand of 60/40 influencing you? I imagine that there are several factors that unconsciously push one away from pure risk parity and toward a more 60/40-ish structure. One, in our investing lifetimes, stocks have reigned supreme. Particularly right now, 10 years into an incredible run for the U.S. stock market, stock market exposure has been the dominant engine that has powered most successful portfolios. It's hard not to subconsciously project that stocks will drive returns going forward, though they may well not. Two, we know that the 70s happened, but we don't feel it in our bones. Most of us didn't live through it when we had real skin in the game. Furthermore, the 70s are absent in many of our back tests and even in data sets like those at Portfolio Charts where the 70s are included, The decade only seems to affect our simulations silently. 3. Tracking error. This is the big one. The farther our returns are away from the performance of the stock market, the more uncomfortable it becomes for us to live through the inevitable periods of underperformance. Marching to the beat of a different drummer is all well and good, but we are social animals, and the truth is that it can be uncomfortable. What I think I have settled on is a middle road. I will have aggressive stock allocations, but I will try to match my stock-like assets with bond-like assets while leaving enough room for alts like gold, commodities, tips, and managed futures. This will, of course, require leverage. Thanks as always for your inspiring work, Alexei. Well, first of all, I don't mind getting emails.

Mostly Uncle Frank [35:11]

In fact, I think that makes this show a lot better to get be getting these emails because then we can have some interaction with this little community and get at what people are really interesting in hearing about.

Mostly Voices [35:24]

You and I travel to the beat of a different drum. How can you tell by the way I run? Every time you make eyes with me. That being said, we cannot focus on just one person's thoughts or emails.

Mostly Uncle Frank [35:43]

There probably will not be any other episodes like this. I don't mention it that often, but I do also offer private consulting. I don't think you need it if you're just thinking about the theory of things, but this is for people who actually have portfolios they are trying to manage and trying to turn into risk parity style portfolios. I'm not cheap. It's $300 an hour. and that's mostly to reduce the numbers of people that want to take me up on that offer, because one or two people a month is enough. But if you are interested, you can email me about that and we'll get it set up. But let's talk about that 60/40 portfolio and how it relates to risk parity style portfolios. The reason I start with that is because this podcast, at least originally, was focused on us people who are retiring and are looking at how we want to structure our portfolio in retirement. So we know that the 60/40 portfolio has been successful and recommended in the past. So it becomes a baseline or a benchmark for deciding what we might do. Because if we can't do or create a portfolio that performs at least as well as that in terms of safe withdrawal rates in particular, then we would just stick with the 60/40 portfolio. And so that is why the 60/40 portfolio is really the benchmark for the portfolios that are like the golden butterfly, golden ratio, and risk parity ultimate. But as to your observation that the 60/40 portfolio has things in common with the golden ratio portfolio, the reason that is, is because the 60/40 portfolio, stocks to bonds, is in fact a golden ratio portfolio just with two assets. I did not know that. You can't handle the truth. The exact proportions would be 61 to 39, but I don't think it's an accident that that proportion has worked broadly for stocks and bonds and that we can take those kind of proportions and apply them to other asset classes to create a broader portfolio along the same lines. that has better performance characteristics. The best, Jerry, the best. And that's really what the Golden Ratio Portfolio seeks to do. But you are correct that there will also be a tracking error between these risk parity style portfolios and a traditional 60/40 portfolio. You are correct, sir, yes. And you can see that if you Look at some of these back tests, particularly year by year, that in years like we just had, or say the late 1990s, when you have extremely good stock market performances, those traditional portfolios, 60/40 or whatever, are going to outperform our risk parity style portfolios. And where our risk parity style portfolios tend to shine is when things are not going so well for the stock market. I do think the easiest way to get comfortable with that is going back and looking at the year by year performance and whether you do that on Portfolio Visualizer, which you can do when you run these things, or you can go to Portfolio Charts and look at something called the Heat Map, which is one of their printouts, which shows you basically how long did each kind of portfolio stay underwater if you started in a bad year. When did it go from red to green on this chart? And that sort of thing will also make you feel more comfortable. In fact, it'll make you feel very comfortable. I'm putting you to sleep. But you always have to keep your goals in mind. And the goals here are to maximize projected safe withdrawal rates and projected perpetual withdrawal rates. And you do that primarily by reducing the length and depth of drawdowns. in any given portfolio. All right, my glass is beginning to empty here. Now there's only one use for money, and that's to make more money. I'll give you one more shot. What else you got for me? I liked this article, although the relative weighting of assets within each regime is not well explained.

Mostly Mary [40:04]

Figure 2 in general is a useful graphic, but it raises several questions that I cannot figure out how to answer for myself. 1. Do you know of any resource that allows us to stress test assets in specific economic quadrants? I'd love to confirm the findings presented. 2. EM and EM bonds credit spreads seem useful in inflationary and growthy environments. Is this a possible argument for adding DGS to an SCV bucket? 3. In which quadrants does SCV outperform the broad stock market?

Mostly Uncle Frank [40:42]

All right, let's go through your questions and then we'll talk about that chart in the article that I will also link to in the show notes. Ask your question. Do you know of any resource that allows stress test assets and specific economic quadrants? I'm not sure that I do, at least not a definitive one. I mean, I've seen various articles and projections of this nature. There are outfits out there right now like Hedgeye and 42 Macro that seek to do this Alhambra Investments. A lot of fund operators and people giving advice and selling advice have tried to take this quadrant format and figure out a trading strategy to go in and out of these quadrants. trading the best things in each quadrant. But what I tend to focus on is the correlations. So you always want to go to that correlation analyzer at Portfolio Visualizer over the broadest time period that you can use and look at the correlations. Then the other interesting way to think about this is to go to the back testers at Portfolio Visualizers and portfolio charts and put in portfolios that are a hundred percent whatever you're interested in, whether it's long-term bonds or commodities or small cap value funds or whatever. And then you can just look at it and see the history over time of when it did well and when it did not. Now you do need to know your economic history that the 70s were an inflationary period. You need to know when the market crashes were, but that's just a story that you can go and research and come up with yourself. I mean, the basic story from about that time is that you had some inflation in the late 1960s, then you had these weird things happen in the Nixon era where there was getting off the gold standard and also wage and price controls that did a lot of screwy things to the economy. And after that, you had a big recession in '73-'74, and then there was a highly inflationary period that actually went into the 1980s. It peaked around 1980 and then came down after that. So we know the 1970s were particularly bad for large cap growth stocks. Other than the recession in '73-'74, they were a good time for small cap value stocks, REITs, commodity producers, commodities, all those sorts of things. The 1980s and the 1990s, they were generally good for stocks. They were good for bonds. They were terrible for commodities, gold, those sorts of things. First decade of the 2000s, bad for stocks, good for bonds, good for gold, and commodities up until like 2007. And then you're well aware of what's been going on in the last decade. So knowing that, it's not that difficult to back test most of these big asset classes to figure out what kind of regime it does well in and what kind of regime it does poorly in. All right, as for emerging markets and emerging market bonds, and credit spreads. And there are a couple problems with just throwing in things because they're new and different. And you might want to go back and listen to episode 125. Somebody was asking about a fund called GAA, which is one of these global asset allocation funds that owns everything under the sun. It does not perform very well. And one of the reasons it doesn't perform very well is there is a lack of discernment in using things. Just because something exists doesn't mean you need to own it. And you end up with two kinds of problems with these sorts of things. One is that they could be highly unpredictable and you might not really know how well they perform in a particular regime. The other problem, and you can see this on that graph in the link that you provided here, It's got this like target over this quadrant system. And in the middle of the quadrant or the middle of the target close to zero, you see things like cash, you see things like tips. What you should take away from looking at that is those things in the middle are going to essentially drag down the performance of any portfolio you put them in because they just don't do very much. if you want a dynamic portfolio that performs well, you want things that are more reactive to the quadrants they're in. And so oftentimes what I see in like commercially prepared funds who are advertising risk parity style investing, they have too much of this stuff in their portfolio and it underperforms. That's what actually happened to RPAR last year because it's got just way too many tips, cash, and these things that are inert and don't really perform that well in an inflationary environment or any other environment. They just sit there. They're dead weight. You should think of those as almost a form of negative leverage that the real performance of the portfolio is what everything else is doing if you just took those things out. So if your portfolio has 20% of short-term instruments, TIPS, cash, those sorts of things. It's almost like you're just working with 80% of the portfolio as to the real drivers of the returns in the portfolio. And so I can tell you that the number one reason I see risk parity portfolios that don't perform very well is they've got too much stuff in there. And TIPS is the primary offender when it comes to that. As to the rest of that article, be careful about it because it's only analyzing a period from 2001 to 2013, which was particularly bad for the stock market and better for other things. So I would take that analysis of the big grain of salt. It appears that article was written in 2013, actually. But it was interesting. Basically, if you followed that, you were making the mistake of relying on the recent past to predict the future. because if you set yourself up in a portfolio like they were talking about in that article in 2013, you didn't do so well the past nine years or so because you were projecting that the future was going to be like the past. And the truth is the future is like some past, but it might not be and probably won't be the immediate past. All right, in your final question, what quadrants does small cap value outperform the broad stock market? It's basically when you're talking about rising growth and inflation or rising inflation by itself. That's basically the story of the 1970s and the 80s. Small cap value stocks did not have a down year between 1975 and 1987, 12 up years in a row, while larger cap and the broader market had a terrible time for most of the latter half of the 1970s and then only recovered after about 1982. You also saw a kind of reverse-ish pattern in the early 2000s after the dot-com bust. The growth stocks did extremely poorly. Some of them lost 90% of their value or all of their value. Even things like Microsoft were down for 13 years between the end of 1999 and 2012. Whereas value stocks of all shapes and sizes did okay in the early 2000s. They lost money, but not nearly as much as the broader market or the growth part of the market. What you can say about that time period is that growth was definitely falling a lot. Inflation was neutral to falling to a little bit up, depending on what you were looking at. Inflation certainly took off in the mid-2000s, particularly in the energy sector. So hopefully that answers your question. But now your Uncle Frank is beginning to fade, and it's time for you to depart so that he can recline in his easy chair and take a little nap. The slogan you can take away is friends don't let friends rely on tips for an inflationary environment. they give them something that works a bit better. We will be picking up this weekend with our weekly portfolio reviews of the seven sample portfolios you can find at www.riskparityradio.com, and we're also going to be talking about the performance of our risk parity style portfolios against the performance of professionally managed risk parity funds. and maybe we'll throw in a couple emails too. 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 put in your message there and I should get it that way. If you haven't had a chance to do it, please go to your podcast provider and like, subscribe to this podcast. Give me some stars in a review. That would be great. Mmkay? Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Voices [50:13]

I'd say in a given week, I probably only do about 15 minutes of real, actual work.

Mostly Mary [50:21]

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.