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 16 of Risk Parity Radio. This is part two of our bond episode. Part one was in episode 14, and you may wish to go back and listen to that if you have not heard it already. Now in part one we went through the first five questions of the 10 questions to ask when considering an investment, the 10 questions to master successful investing from David Stein and Money for the rest of us. And now we're going to tackle the next five questions and I will link to those in the show notes so you can have all 10 available to look at. Question six is what is the investment vehicle? Now, the investment vehicle for bonds is one of two things generally. You can buy bonds individually and just own them straight out, or you can buy them as part of a fund, either an ETF or a mutual fund. And most of our bond buying these days does occur in the context of funds. And as I mentioned in the last episode, part one, there are many different bond funds for many different kinds of bonds. In the world today you can find a fund for just about any class of bonds that you want to consider owning. And so in our correlation matrix that we will link to again, We have about 13 different funds for the various classes which we described in episode 14. Funds are the easiest way to own bonds, just as they are the easiest way to own stocks or many other things. Question 7. What does it take to be successful? Well, it really depends on what you are doing here with bonds. Mostly it takes a little bit of patience. Now there are a couple different ways you can approach investing with bonds. What some people do in the classic sense is to form what are called bond ladders, where they will buy individual bonds and hold them until maturity. Until they'll have a one-year bond, a two-year bond, a three-year bond, a four and a five, and will hold each of those to maturity then replace it with the longer term bond that is an old classic strategy that many people followed before there were all of these bond funds. Now if you're investing in bond funds, those are already laddered in a large sense. If you look inside, for instance, what is in an intermediate bond fund, you will see bonds of seven to ten years of duration, for example, and the bond fund management will be retiring the seven-year bonds when they turn into six-year bonds and then buying new 10-year bonds with those funds. And so those will be rolled over to keep them consistent with the mission of the bond fund. The most important thing to be successful with a bond fund is similar to the long-term success for owning stock funds, which is to be patient and to set an allocation, and then be willing to buy more bonds when those funds decline in value and sell some bonds when those funds increase in value in a rebalancing move or situation. And that is how you end up buying low and selling high. The way not to be successful, if we invert the question, is to try and guess what interest rates are going to be. If you are trying to guess what interest rates are going to be in the future, you are probably going to be unsuccessful at investing in bonds, simply because you will be jumping in and out of bond funds or you will be investing in the wrong bond funds for your portfolio. based on your prognostications. One of the most interesting dichotomies I see in the financial world is that people are very willing to accept that they cannot predict the future of the stock market, at least on a short-term basis. Yet they are not willing to accept that they cannot predict what interest rates will be. And so you have many people adopting a conventional wisdom that interest rates have to go up. I heard somebody on a podcast this week saying, well, I'm concerned about owning bonds because, you know, interest rates are going to go up sometime. And then he said right after that, of course, I've been saying that for 10 years and I've been wrong. Now think about that. If you've been wrong about something for 10 years and you don't know why you're wrong, why would you continue to be wrong and believe the same thing. If you listen to the intro of this podcast, that's what foolish consistency means. You continue to believe something that has been proven to be wrong over and over and over again because you'd rather be consistent and wrong than have to change and admit you were wrong and come up with a different plan. Now, question eight：who is getting a cut? If you look at bond funds and you need to be careful looking at them because some of them are managed and some of them are pretty darn expensive management. Now, I was watching a video on YouTube from somebody associated with one of the big rating companies and they were talking about a particular bond fund, which I will not mention, but they were saying, what I really like about this bond fund is the management. Well, what is so great about the management? The fees for this bond fund were 1.69%, and that is a lot for a bond fund that is only paying three or four percent. You are really paying a lot of money for something like that. That is probably too much for a cut for a bond fund. You should be looking at bond funds with expense ratios that are much less than 0.5, down to 0.15 or even less than that. That is what you should be looking at. Nobody should be overpaying for their bond funds. But now let's get to the most interesting question of the day, which is question number nine. which is how will bonds impact your portfolio, your risk parity style portfolio? And the short answer is different funds will affect your portfolio very differently depending on what kinds of bonds are in them. And to evaluate what kinds of bonds might be appropriate for your risk parity style portfolio, We need to go back to our principles, and if you go back to episode 7, you will find that one of our principles is the Holy Grail principle from Ray Dalio, which is that in order to construct a risk parity style portfolio, you need to find uncorrelated assets or negatively correlated assets. And so since what is in most of our portfolio is stocks, we need to be looking at the bond funds in terms of which ones are the least correlated with our stock funds, because those are going to give us the best match up in terms of reducing our volatility while maintaining are returns. Because if you look at all the bond funds, you can see that many of them have similar interest rates. You can find corporate bonds that have similar interest rates to treasuries. You can find international bonds that have similar interest rates to the corporates, depending on the issuer and the counterparty risk. So the real differences In terms of bond funds come down to these correlations for the bonds. There is also another consideration, which is the volatility of the bonds. And we talked about this in the prior episode, episode 14, that long duration bonds are more volatile than short duration bonds. Now that can be both good and bad. When is that bad? It is bad when those bonds are correlated with your stocks because if you have volatility that is going in the same direction most of the time, it increases the volatility of your portfolio. But if those bonds are negatively correlated with the other things in your portfolio, then the increased volatility of the bonds will actually reduce the overall volatility of your portfolio. And this is a very difficult thing for people to understand. Because what people want to do is look at bond funds in a vacuum and just look at, well, this has this interest rate and this amount of volatility without considering is that volatility in the same direction as the other things in the portfolio or not. And unless you take that element, put it into the portfolio, and actually test it, you will not understand what a particular bond fund will actually do for you in your portfolio. You will get a misunderstanding of which bond funds you might want to hold if you're looking at them each in a vacuum. Let me give you a couple of analogies for that. One is baking a cake. I was looking at a cake recipe online last week. It was for a chocolate mocha cake. And so, as you can imagine, most of what goes into a chocolate mocha cake are flour and sugar and some kind of chocolate. But what else goes into this cake? There was vinegar in this cake. There was stout beer in this cake. And there was some coffee in this cake. Now, if you took those things, if you said, well, I'm going to put vinegar in a cake. Most people would say, well, I don't want a cake that tastes like vinegar. Well, that's not the point. The point is the cake is not going to taste like vinegar. The cake is going to be a great chocolate cake, but it's because you put in this mixture of ingredients. The sum is not the same as the individual ingredients. Let me give you another example. This comes from my background. One of my degrees is in material science engineering. And one thing you learn in material science engineering is that when you create a material, say a kind of steel, you cannot necessarily predict the properties of that material simply by looking at its ingredients. You actually have to combine them, create the material, and then test it to see what its properties are. And so that is why You take something like carbon, which is not very strong and not very ductile, and combine it with iron, that's how you make steel. And if you want that steel not to rust, you need to put something else in there. You need to put chromium in there. And that's how you make stainless steel. But you wouldn't know that. You wouldn't know the properties of that material. until you actually made it, until you put it all together. And that is how you need to look at bonds in your portfolio. Not what are the properties of that bond fund in a vacuum, but what are the properties of your portfolio when you put that bond fund in there. And you can't find that out unless you go and run some back testing, unless you look at some correlation matrices. Unless you consider the whole picture and not just the individual picture. Now taking those principles and looking at the universe of bond funds that we had talked about, these 13 bond funds, let's go through them and take a look at some of them. And thinking about that Holy Grail principle, it makes it easy for us to eliminate a lot of these bond funds. We can eliminate them because we see that they are correlated, highly correlated with stock funds. And so they violate the Holy Grail principle. They are not going to improve the volatility or reduce the volatility of the portfolio if they are going bad at the same time your stock funds are going bad. And you saw this happen for a lot of corporate bond funds. In March, people thought they had something that was going to protect them in a downturn, and lo and behold, they found that those funds went into the tank at the same time the stocks did. And what kinds of funds were those? You can see that if you look at this correlation matrix. If you look at the first column, we have VTI, which represents the stock market, and then for each of the bond funds, you can see the correlation with the stock market. So which one is the highest one? The highest one is high yield bonds, corporate junk bonds, and that comes in at 0.79% correlated with the stock market. That is as correlated as many stock funds. That bond fund would have to pay an extremely high interest rate for it to be of any use to you whatsoever. in a risk parity style portfolio. That's an easy one to just toss out. Which other ones look to be with high correlations? That one was HYG, by the way. Let's look at the corporate bond funds and the international corporate bond funds. And we see correlations there of plus 0.5%, plus 0.49, plus 0.49, plus 0.35, and that's for IBND, IGSB, IGIB, and IGLB. Now, what does that tell you? That tells you that those are also correlated with the stock market. When the stock market goes down, those bond funds are gonna go down in value with the stock market. They have the same kinds of correlations that you would find in a fund that invested in utilities, or in some REIT fund. So perhaps you want to own one of those, you're probably going to get more return out of them. They certainly aren't going to help you in reducing the overall volatility of your portfolio owning those sorts of things. And this gets to why a total bond fund is never going to be an ideal bond fund for you because most total bond funds have a high percentage of these corporate bond funds in them. They have 30% in BND, some of them have more. So you're really acting at cross purposes. You don't want to own corporate bonds in most risk parity style portfolios, unless you were doing something awfully strange where you had a, you didn't have any stocks in your portfolio and you were just matching up different types of assets. So where does this get us to? Now we're getting down the list to bond funds that have near zero correlation with the stock market. And these include municipal bonds, international treasury bonds, that's MUB and IGOV in the ones we're looking at, and the TIPS. TIPX and LTPZ. Those all come in with correlations between positive 0.03 and positive 0.23. Now that's not bad. They are perhaps useful, but maybe not as useful as others. You will find that if you own short-term treasury bonds or short-term bonds in general, they perform a lot like cash. They also have this zero correlation or Very low correlation. Where that is nice is if you are just looking for something to hold for the short term and you don't want it to be volatile by itself at all. Now, will that reduce the overall volatility of your portfolio? Yes, it will some in the same way that if you have a portfolio that is half cash and half stocks, It's going to have half the volatility of a portfolio that's 100% stocks. So it's the obvious, but it's not exciting. I will tell you, from personal experience, that I did own TIPS during the great financial crisis in 2008, because I thought, from reading some books and some recommendations from famous economists, that that was going to be the way to go. But lo and behold, in the fall of that year, coming up on the 12th anniversary of that, those tips went down. Those tips went down when I needed them to be stable or to go up. And that was not fun, but it was a learning experience as to making better choices in the future about which bonds to own. So this gets us to what are the bonds that are negatively correlated with the stock market, that are really going to give us the most diversification bang for our buck that are going to be lining up with that Holy Grail principle. They are the treasury bonds and the mortgage-backed securities. And you'll see from our list that the treasury bonds have negative correlations with the stock market ranging from negative 0.34 to negative 0.43. And the mortgage-backed securities have a smaller but negatively correlated number viS-A-Vis the stock market. VMBs here has a negative correlation of 0.19. So what does this tell us? Well, this tells us that these kinds of bonds are going to go up in value when the stock market declines. And if you looked at what happened earlier this year when the stock market declined, you saw that these bonds went up in value. Now how much did they go up in value? Well they went up in value based on their duration, because that goes along with it. So the long-term bonds went up the most in value. and they were up about 25% in the worst of it when the stock market was down the most. And the shorter term bonds were up anywhere between 5% and 25% depending on what the duration was. And here is where you see how the volatility of these long-term bonds can actually work in your favor. And again, this goes back to the vinegar and the cake. Volatility by itself is bad, but volatility of multiple asset classes in a portfolio that is uncorrelated volatility will cancel it out and will lead you with a less volatile portfolio than you would have had you picked something else. And that is really the point there of those bonds. And so you end up Coming down to the inevitable conclusion that the best core bond holding in your long-term risk parity style portfolio is going to be an allocation to long-term treasury bonds. Not because they are the most stable, but because they are both uncorrelated with your or negatively correlated with your stocks, and the volatility works in your favor because it goes in the opposite direction. Now, how has a fund like TLT actually performed in a vacuum over the past 10 years? I will link to the prospectus for TLT in the show notes, but if you go and look in that, and it's on page S7 of the full prospectus, you can see how volatile this was over the past 10 years. In 2010, it was up 9.286%. In 2011, it was up 33.6%. Have you ever heard of a bond going up 33.6%? That is also why the nominal interest rate that it pays is completely irrelevant. It's completely dominated by the capital appreciation of this bond. In 2012, it was up 3.25%. and then you saw it go down in 2013, 13.91%, and up 27.35% in 2014. Then down in 2015, 1.65%, up 1.36 in 2016, up 8.92 in 2017, down 2.07 in 2018, 2018 and up 14.93 in 2019. Now what would you have been doing with that had it been in your portfolio during that time period? What you would have been doing in your risk parity style portfolio is rebalancing it annually. And you would have been buying those bonds when they went down and you would have been selling those bonds when they went up. Because guess what else was happening at the same time? When those bonds were going up, your stocks were probably going down. So you were selling those bonds high and you were buying your stocks low. And then when the bond funds went down, your stocks are probably doing pretty well then. And you could sell some of those stocks high and buy the bonds low. And that's what you'll see out of a bond fund like this. It's not going to go all one way all the time. It's going to go up and down. And so if we look at the overall performance of that fund for the past number of years, in the past year it's up 25.77%. Three-year period up 12.14%. Five-year period up 9.41%. Ten-year period up 7.89%. Since inception, which is over 20 years, it's 7.65%. Now, I will tell you during that same period of time we've been listening to the pundits tell us about, oh, you can't own those things because the interest rates are going to go up someday and then they're not going to be worth as much. And we're still waiting for that to happen. I would not predict that interest rates are going to go up. I would say they're probably going to go up and down like they've gone up and down. for the past 20 years. And while they're going up and down, if you hold them in your portfolio, you'll be rebalancing into them and out of them and making a profit and keeping your overall volatility of your portfolio quite low. Now, you don't need to take my word for this, and you shouldn't. You should look at these things yourself, and it is amazing What people discover when they do take a look at these things for themselves and they don't look at the bonds in a vacuum, they look at them in their portfolio. I'm going to link to a website called Keep Investing Stupid. I'm sorry, Keep Investing Simple Stupid, which is by Dan Huffman, who is a Facebook friend of mine. And he had been working on coming up with a good all stock portfolio. But then he decided, well, what bonds might he include in this portfolio to smooth it out or make it a little better? And so he analyzed several different bond funds. And what he came up with surprised him. What he came up with that surprised him is that long term treasury bonds were the best choice, not in a vacuum, but in the overall portfolio, because of those negative Holy Grail correlation characteristics. So when he did his analysis, and I'll link to it in the show notes, he found that adding long-term treasury bonds to his stock portfolio, which he calls the KISS portfolio, gave him the highest safe withdrawal rate, the highest perpetual withdrawal rate, the highest gain loss ratio, the highest upside capture ratio, and overall the best rolling returns over every time period that he analyzed the portfolio for. And he was admittedly very surprised by this, because like the vinegar in the cake, it's not obvious from just looking at these bond funds in a vacuum, how they're going to affect a particular portfolio until you put them into the portfolio and do the analysis. And he did the analysis at the websites that we recommend, Portfolio Charts and Portfolio Visualizer. These are free, and you can put your portfolio in there with whatever bonds you want to test out and run these comparisons for themselves. Along those lines, I have another Facebook friend named Luke Swanson who did another analysis for his own portfolios, which is also on the Keep Investing Simple, Stupid website in a separate post. He basically concluded the same kinds of things that at least with respect to bonds, the real issue was Which ones were the best ones? And the long-term treasury bonds, when combined with other things, allowed for the best portfolio performances over time. And whether he was using that as a retirement portfolio or something intermediate he was really thinking about over the next 40 years of his investing life, what would he want to have? What kinds of portfolios would he want to have at various ages? And so you'll see that analysis, it's also very interesting. Which leads us to question 10：Should you invest in bonds? And the answer is yes, but make sure you pick the right ones for what you're trying to do. If you are constructing a risk parity style portfolio that is based largely on stocks as the main driver, then you're going to want some long-term treasury bonds in there to smooth out that volatility, that overall volatility. If you are constructing a different kind of risk parity style portfolio, perhaps you want different kinds of bonds in there. Now, if you are still in your accumulation phase, perhaps you don't need any bonds at all because you are really relying on time to smooth out your portfolio. You're not drawing down on it. You don't have these kinds of considerations. But when you get to that drawdown phase and you're looking to construct a robust portfolio that will give you the best drawdowns, the best safe withdrawal rate, you're probably going to want those long-term treasuries in your portfolio. Whether you want some of these other bond funds, that's neither here nor there. Sometimes it's good to have a short-term bond fund. It behaves like cash and some of our risk parity style portfolios do have those in them. You can take a look at those portfolios on the portfolios page, the sample portfolios page. You'll find it www.riskparityradio.com and click on the portfolios and you'll see those. But now I see our signal has beginning to fade. This has been a long episode, so thank you for your attention to it. There will be lots of links in the show notes. I will even link to that recipe for the cake if I can find it again. The next episode will be this weekend. It will be our Portfolio Review, our weekly portfolio review, and I hope you'll tune into that. If you have any questions or comments, please send them to frank@riskparityradio.com that email address again is frank@riskparityradio. com or you can put them in on the contact form on the website itself. www.riskparadioradio.com Thank you once again. This is Frank Vasquez for Risk Parity Radio, signing off.

Mostly Mary [31:38]

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.