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 [0:36]

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 foundational episodes for this program. And those are episodes 1-3-5-7-10. and nine. One of our listeners, Karen, has also reviewed the entire catalog and has additional recommendations as foundational episodes. Ain't nothing wrong with that. And Karen's recommendations are episodes 12, 14, 16, 19, 21, 56, and 82, in addition to the first five that I mentioned. Now, I realize women named Karen get a bad rap these days, but I assure you that all of our listeners are intelligent, thoughtful, and savvy. Yes! And don't forget that the host of this program is named after a hot dog.

Mostly Voices [1:39]

That's not an improvement. Lighten up, Francis.

Mostly Uncle Frank [1:46]

But now onward to episode 172. Of Risk Parity Radio. Today on Risk Parity Radio, we're going to do what we seem to do best here, which is try to catch up on some of our emails from April. And so without further ado, here I go once again with the email.

Mostly Voices [2:06]

And first off, first off, we have

Mostly Uncle Frank [2:10]

an email from Andy.

Mostly Mary [2:18]

And Andy writes, hi Frank, on your recommendation, I started listening to the Rational Reminder podcast. It seems excellent. They like factor investing, which I had never heard of before. I saw a paper online that talked about using factors to generate a risk parity portfolio. If it makes sense for your broader audience, are you able to help situate factor investing in the context of risk parity portfolio construction, please? Thanks, Andy.

Mostly Uncle Frank [2:43]

Well, this is a great question, Andy, because it gets right to the heart of what is wrong with a lot of the ways that amateurs approach investing, and in particular constructing a stock portfolio of index funds. And I always like to say that to understand any idea, you need to first understand what the history of that idea is and where it came from, and then you can decide how valid it may be then and now. Well, I like to do the job right. If you go all the way back into, say, the 1980s and think about how fund managers were trying to construct diversified portfolios back then, there wasn't a lot of science to it.

Mostly Voices [3:28]

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

Mostly Uncle Frank [3:35]

And there wasn't a lot of academic research on it. And it's through the candle.

Mostly Voices [3:41]

that you will see the images into the crystal.

Mostly Uncle Frank [3:45]

So it was kind of like, well, this is different than that, therefore they must be diversified.

Mostly Voices [3:53]

You can actually feel the energy from your ball by just putting your hands in and out.

Mostly Uncle Frank [3:57]

And so out of that you got a couple of ideas. One was that things like international stocks must be diversified from US stocks because they're headquartered in different places. Which was a lot more true back then than it is now.

Mostly Voices [4:13]

Which is huge.

Mostly Uncle Frank [4:17]

Another idea was, well, if we invest in these stocks that pay dividends, that's kind of different from the rest of the market, isn't it? Which also turned out to be not really true. Forget about it. And then really the next big idea was the idea of sectors. Cornbread. Ain't nothing wrong with that. That you would divide up the stock market into its industry sectors. So you would have consumer staples and energy and materials and utilities. And so there was an effort to carve up the stock market into what became 10 sectors, and it's now 11 sectors. And then there were funds developed around those sectors. And most of them turned out not to be that diversified from the stock market, but a few of them were notably REITs and utilities and also energy at some points in time. But the search was on then for ways to divide up the stock market that would make sense to create more diversified portfolios and give you different characteristics of stocks that were actually meaningful in terms of performance. And out of that came the seminal paper by Eugene Fama and Ken French in 1993. And what they had discovered there was that certain factors, namely size and what they called the value factor, were very important in distinguishing stocks both for diversification purposes and performance purposes. And in particular, that's where the concept that small cap value stocks tended to outperform the market over decades of history and also were diversified from the rest of the stock market, or at least the larger portions of the stock market. Now, since that time, researchers have come up with hundreds of potential factors Most of which are spurious and do not lead anywhere. However, there are sort of the big five that professionals and researchers focus on now, and they are value, size, momentum, quality, and volatility. Surely you can't be serious. I am serious.

Mostly Voices [6:44]

And don't call me Shirley.

Mostly Uncle Frank [6:48]

And I will link to a couple articles in the show notes from Investopedia and Wikipedia describing the basics of these. But most professionals and hedge fund managers use these factors to construct portfolios because they are the best thing available. And now we have all kinds of funds that reflect these factors that make it very easy for us as do-it-yourself investors to incorporate this into the stock side of our portfolios. Now the two most popular are value and size factors. And you'll see these if you go to say a Morningstar report about a fund, you'll see a thing with nine boxes in it with size on one axis and value growth on the other axis. And then they categorize each fund by its size and its value or growth characteristics. and classify them that way. Now in the context of risk parity portfolio construction, these are very useful because this is the best way to actually divide up your funds and decide what to invest in. That these factors ought to play the largest role in picking a variety of funds. And if you plug them into a correlation analyzer, you can see that They are in many respects different and diversified, actually diversified in a numerical way much better than, say, international or dividend paying or a lot of the sector funds. So it is just a superior way to go about portfolio construction. And there's no reason anymore that amateurs can't do it almost as well as professionals because we have all these ETFs out there. that reflect all these factors.

Mostly Voices [8:40]

We have the tools, we have the talent. And they're cheap and they're easy to use.

Mostly Uncle Frank [8:44]

That is the straight stuff, O Funkmaster. So let's just take one of our sample portfolios and take a look at it and think about how these factors apply. If we look at the sample portfolio for the golden ratio, which you can find on the portfolios page at www.riskparityradio.com, Most of the stock portion of that is comprised of three funds that are divided by factor. One is a large cap growth fund. One is a small cap value fund. You're gonna want that cowbell. Now, if you're only gonna pick two funds for your stocks, those would probably be the two things you would want to pick because they're on the opposite end of a diversification spectrum. Yes. You will also see in there what is called a low volatility fund. This one is USMV. And in this context, volatility is usually expressed as what they call beta, which is in this case, stocks that tend to move less than the overall market. They have betas of less than one. The idea of having low beta is to make your portfolio a little bit more conservative. and less volatile overall. If you were going on the high beta side, you'd be going for more speculation. Now in that portfolio, those are the three core funds we have chosen. And you can also see we've added a REIT fund, which is a sector fund, which is also pretty well diversified from those three. And the upshot of this is now that we've had this research around for about 30 years, And we have all of these funds that are able to do this. There's no reason why an amateur investor should not be using factors as the basis for constructing the stock portion of their portfolio for the most part. Am I right or am I right? Am I right? Am I right? Am I right? So if you, for example, are interested in international stocks because you feel they're different from your US stocks, You really should be focusing on factors within that group of stocks.

Mostly Voices [10:56]

I think I've improved on your methods a bit, too.

Mostly Uncle Frank [10:59]

So, for instance, a global international fund like VXUS is a poor diversifier from a total US stock market fund. It just is.

Mostly Voices [11:08]

That's not an improvement.

Mostly Uncle Frank [11:11]

You're going to be much better off if you incorporate some factors into that. All right.

Mostly Voices [11:15]

What do you got for me, Coach Z?

Mostly Uncle Frank [11:19]

In particular, if you take some small cap value out of emerging markets or developed markets with funds like AVES and AVDV, which are relatively new but incorporate this methodology.

Mostly Voices [11:33]

I'm telling you fellas, you're gonna want that cowbell.

Mostly Uncle Frank [11:41]

And those are going to be a much better choice to make than something that is also large cap growth and value stocks, like a VXUS. It doesn't work for me.

Mostly Voices [11:49]

I gotta have more cowbell.

Mostly Uncle Frank [11:53]

If you are somebody who would be previously interested in, say, funds that pay dividends, what you should be really looking at there are two factors. One being the volatility factor, in particular, low beta, and the other one being quality, which is going to overlap with things that tend to increase dividends. But these are going to describe groups of stocks that are much better positioned for what you're really trying to do with these things.

Mostly Voices [12:24]

Guess what? I got a fever, and the only prescription is more cowbell.

Mostly Uncle Frank [12:31]

Now ultimately with whatever you're looking at, you ought to be putting it into an asset correlation analyzer to see whether it is actually diversified in a numerical way. and you should also be running back tests as best you can with the funds or types of funds that you've selected to see how they work together. And if you do those things, you will come up with portfolios that have better return characteristics and better diversification than the sorts of simplistic things that people came up with 15 or 20 years ago that are now obsolete. Forget about it. And then to that, For a risk parity style portfolio, then you are going to not only diversify numerically within the asset class, then you're going to apply that principle across asset classes to incorporate different things into your portfolio that are in fact diversified from those stock funds that you picked. And you need to look at everything together. There's no such thing as a stock portfolio and a bond portfolio and a Alternative portfolio. It's all one big portfolio and you need to analyze the whole thing together. Yeah, baby, yeah! Otherwise you're going to get suboptimal results. But I think that is probably enough on that, at least for today.

Mostly Voices [13:48]

Bow to your sensei. Bow to your sensei.

Mostly Uncle Frank [13:52]

And thank you for that email. It's a very interesting topic. Babies.

Mostly Voices [14:00]

Before we're done here, y'all be wearing gold-plated diapers. Second off.

Mostly Uncle Frank [14:06]

Second off, we have an email from my contact info again.

Mostly Voices [14:09]

Oh, I didn't know you were doing one.

Mostly Mary [14:13]

And my contact info writes, Frank, appreciate your financial nanny analogy and the sound effects. reminded me of valuation, which is inherently difficult given that cash flows need to be estimated. Crystal Ball. A really big one here, which is huge. But the correct principles are not overly complex. Similar to investing, my observation is that many active managers slash brokers simply fail to understand basic valuation principles or fail to articulate either intentionally or unintentionally the simple basics of valuation. Proper valuation and a correct understanding of corporate finance is essential for equity prices to gravitate toward intrinsic value. But I sense that like the basic investment principles you espouse, which ultimately require that markets function, the core tenets of valuation and relatedly corporate finance are subject to the same financial nanny forces. Thank you.

Mostly Voices [15:19]

Well, first I should say, as usual, You are correct, sir, yes!

Mostly Uncle Frank [15:27]

It is definitely true that the principles of valuation are not that difficult to understand and there are lots of formulas and lots of spreadsheets that can run those sorts of things for you. The difficulty is always on the inputs because you are in fact trying to assess the future of a business or a group of businesses whenever you're looking at valuation and by its nature you are making predictions with your inputs. And so the outputs you get and the decisions you might make on them are only as good as your inputs. And so it is in fact very difficult for amateur investors to use principles of valuation as a practical matter in selecting investments. In order to do it the right way, you'd have to do it the way Warren Buffett does it, which is get into the weeds as to the financials of a particular business and then all of the ins and outs of that business, because it's that level that you have to get to in order to successfully use valuation in investment selection. I think there are a lot of popular but kind of spurious uses of it. People trying to predict things by PE ratios, or any other kind of ratio that they can come up with. Now, the crystal ball has been used since ancient times.

Mostly Voices [16:50]

It's used for scrying, healing, and meditation.

Mostly Uncle Frank [16:54]

And those kind of superficial attempts, by and large, just don't work in terms of a mechanism for selecting investments. That's not how it works. Because they're just far too simplistic for the complex world that we live in.

Mostly Voices [17:10]

That's not how any of this works.

Mostly Uncle Frank [17:13]

And so it is much better to admit what we cannot do very well. Man's got to know his limitations. And then work within those parameters than to be sitting around trying to forecast cash flows for businesses or groups of businesses or interest rates or anything else.

Mostly Voices [17:31]

You can't handle the dogs and cats living together.

Mostly Uncle Frank [17:35]

And your average financial advisors are not in any position to do that any better than you are really. Forget about it. Because if they were, they would be working for Berkshire Hathaway or a hedge fund or somewhere else. We do that for 40 years and then we die.

Mostly Voices [17:54]

And thank you for that email. Last off.

Mostly Uncle Frank [18:01]

Last off, we have an email from James, and James writes Evening,

Mostly Mary [18:06]

Uncle Frank. In a previous episode, you discussed the WisdomTree Efficient Gold Plus Equity Fund, GDE. And while I will not be utilizing it in any of my portfolios at present due to its extremely low AUM, 1.3 million versus NTSX's 900 million, I love the idea of this fund and came up with an excellent use case that I will likely implement once the fund gets some legs. I would use it to construct the following Golden Butterfly inspired portfolio：35% GDE, 31.5% Gold, and 31.5% US large caps, 32.5% Small Cap Value Fund, 32.5% long-term Treasuries, This breaks down to a 1.28 times levered version of the following, give or take a half a percent：25% gold, 25% large caps, 25% small cap value, 25% long-term treasuries, which is just a golden butterfly without the cash. I currently use a similar portfolio for my taxable account：30% NTSX, 30% AVUV, 25% GLD, 15% TLT, but would replace it with the former portfolio in a heartbeat, as I would much rather have free gold than free intermediate treasuries. Keep up the great work. Risk Parity Radio is hands down the absolute best investing podcast out right now.

Mostly Uncle Frank [19:37]

James. The best, Jerry. The best. Well, James, thank you for that nice compliment.

Mostly Voices [19:46]

Well, Laddie, frickin' da.

Mostly Uncle Frank [19:50]

I doubt it's true. Au contraire. But as they say, flattery will get you everywhere. Yeah, he's home, dynamite, and he needs all the help he can get. Now, just to get everyone up to speed, what James is referring to is something we talked about in episodes 167 and 170. And I should also mention that episode 167 was where we also talked about financial nannies. that were mentioned in the last email. But anyway, this fund GDE is a new fund from WisdomTree that combines an investment in gold and an investment in the S&P 500, and then adds some leverage to the mix. So in theory, it could be a candidate for creating a leveraged risk parity style portfolio, and several of my listeners have jumped on it and thought about what they might do with it. Let you know what I have to say about those things.

Mostly Voices [20:54]

You have a gambling problem.

Mostly Uncle Frank [20:57]

Actually, it looks like a very interesting fun to me. It's just that the fact that it's so new leads me to just put up a little caution flag that we ought to see how it performs for a couple of years to see whether it actually performs as advertised.

Mostly Voices [21:14]

Well, you have a gambling problem before we decide that we really want to

Mostly Uncle Frank [21:17]

incorporate it into anything we're doing. You can't handle the gambling problem. But I think all our listeners should also note how James has incorporated small cap value stocks into his portfolio. I gotta have more cowbell. Which I think is now pretty clear are one of the key ingredients to a well-diversified portfolio, especially on the stock side. And I will also post a link to your current portfolio involving the NTSX in Portfolio Visualizer so people can check that out if they'd like to see it. Because it looks interesting to me too. Young America, yes sir. And thank you for that email. But now I see our signal is beginning to fade. Afraid to have to make this episode a little shorter, if you don't mind. We'll pick up again this weekend with our weekly portfolio reviews of the seven sample portfolios you can find at www.riskparityradio. com, as well as probe into some more emails, because we're getting behind. 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 your message into the contact form and I'll get it that way. For more risk parity materials in blog form, you may check out Risk Parity Chronicles, which is the site founded by one of our listeners, Justin that has a lot of information in blog form that you may wish to peruse. If you haven't had a chance to do it, please go to your favorite podcast provider and like, subscribe, give me some stars, a review.

Mostly Voices [23:14]

That would be great.

Mostly Uncle Frank [23:18]

M'kay? Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Voices [23:26]

Let me put it this way. Have you ever heard of Plato, Aristotle, Socrates? Yes. Morons. Really?

Mostly Mary [23:33]

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.