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 [0:18]

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. Thank you, Mary, and welcome to Risk Parity Radio.

Mostly Uncle Frank [0:49]

If you have just stumbled in here, you will find that this podcast is kind of like a dive bar of personal finance and do-it-yourself investing.

Mostly Voices [0:53]

Expect the unexpected. It's a relatively small place.

Mostly Uncle Frank [0:57]

It's just me and Mary in here. And we only have a few mismatched bar stools and some easy chairs. We have no sponsors, we have no guests, and we have no expansion plans. I don't think I'd like another job. What we do have is a little free library of updated and unconflicted information for do-it-yourself investors.

Mostly Voices [1:24]

Now who's up for a trip to the library tomorrow?

Mostly Uncle Frank [1:27]

There are basically two kinds of people that like to hang out in this little dive bar. You see in this world there's two kinds of people my friend. The smaller group are those who actually think the host is funny regardless of the content of the podcast. Funny how, how am I funny? These include friends and family, and a number of people named Abby. Abby someone. Abby who? Abby normal. Abby normal. The larger group includes a number of highly successful do-it-yourself investors, many of whom have accumulated multimillion dollar portfolios over a period of years. The best Jerry, the best. And they are here to share information and to gather information to help them continue managing their portfolios as they go forward, particularly as they get to their distribution or decumulation phases of their financial life.

Mostly Voices [2:39]

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

Mostly Uncle Frank [2:43]

But whomever you are, you are welcome here.

Mostly Voices [2:47]

I have a feeling we're not in Kansas anymore.

Mostly Uncle Frank [2:55]

So please enjoy our mostly cold beer served in cans and our coffee served in old Chipton cracked mugs, along with what our little free library has to offer.

Mostly Voices [3:14]

But now onward to episode 227.

Mostly Uncle Frank [3:19]

Today on Risk Parity Radio, we're just gonna do what we seem to do best here.

Mostly Voices [3:26]

And so without further ado, here I go once again with the email.

Mostly Uncle Frank [3:32]

And first off, we have an email from Bradley, and Bradley

Mostly Mary [3:36]

writes, Hi Frank, I've been listening to your podcast from early on. Still enjoying, of course. This is my second time writing in. Some background, I'm 38 and married. My wife and I are pursuing financial independence, but once we hit that number, we'll probably drop down to part-time rather than retire early. At work, my 403b has a Roth option as well. I don't have all the details because I'm not sure it's even worth looking into yet. My wife and I both already max out our IRA Roths, but we're not quite able to max out 403Bs yet. Any reason I should pursue the Roth option of the 403B? Who would it benefit doing this, and in what scenario? Well, Bradley, to Roth or not to Roth, that is the question.

Mostly Voices [4:26]

Now go away or I shall taunt you a second time!

Mostly Uncle Frank [4:30]

This is something that actually gets written about ad nauseam all the time in various places. And there is no one answer to it because it depends largely on your own personal situation and in particular your tax situation now and what you think it is likely to be when you get to be using your assets. Now, your current self always wants to do traditional because then you get to save more money now. your future self always wants you to do Roth today because having Roth money is the best kind of money you can have once you get to retirement because it's never going to be taxed. So ideally when you're very young and your salary is low, that is the time you stuff your roths. And then as you go forward, depending on your tax situation, you shift over to your traditional 403Bs, 401Ks, and IRAs. I'm putting you to sleep.

Mostly Voices [5:32]

If you're looking for a rule of thumb that may or may not apply to

Mostly Uncle Frank [5:36]

you, generally if your marginal tax rate is less than 20%, you should be thinking Roth. If it's greater than 30%, you should be thinking traditional. And if it's in the 20s, it's a choice. and you can change that choice year to year. I will tell you it is nice to have some Roth money at the end of the day. It's funny if you listen to the Money Guy podcast, they talk about a bucket strategy of having buckets of Roth money, traditional IRA or 401K money or 403B money, and an ordinary brokerage account money when you get to retirement. And it is much easier to manage your situation if you have more options and not everything you have is stuck in the traditional 403 or 401. The reason for that is those are the most inflexible accounts at the end of the day because they generate ordinary income when you take the money out of them. And then they also generate RMDs. Whereas if you have a Roth and you put it into a Roth IRA, you'll never be subject to RMDs when you get older. Depending on when you're going to retire, there may be a nice gap which you will use for conversion time. So if you retired in your late 50s and you could forestall taking Social Security until you're 70 or almost 70, there's a big gap in there where your income is extremely low. and that is the place where you would do conversions out of your traditional 403b into a Roth IRA. First, you would probably move it into a traditional IRA and then do the conversions. This has also become a more important issue in terms of inheritances because these days, the traditional IRA 401k or 403b is probably the worst thing that somebody could inherit other than some kind of variable annuity, because you have to disgorge the funds within 10 years and it gets taxed at ordinary income rates of the person inheriting it. That's probably not a concern at age 38 for you, but it is part of the new reality with respect to these kinds of accounts since they changed the law a few years ago. Now you did mention that you guys plan to Retire early or go down to part-time at some point before traditional retirement age. That would argue for doing the traditional 403 now if you believe that your income is higher now than it's likely to be later. The one thing I would caution you not to do is something that is encouraged by people that run steak dinners and sell annuities in things. You know, whenever I see an opportunity now, I charge it like a bull.

Mostly Voices [8:37]

Ned, the bull, that's me now.

Mostly Uncle Frank [8:41]

and they are always saying that taxes are going to go up in the future, and so you better get into these things that they're selling now. In fact, trying to predict future tax rates that have not been written down yet is a fool's errand, and it's not something you ought to be engaged in. He didn't fall?

Mostly Voices [8:59]

Inconceivable.

Mostly Uncle Frank [9:03]

If you're going to engage in that kind of game, your best assumption is that tax rates will remain similar, although we know that it's written into the law right now that they're going to go up slightly in a couple of years. But the other thing annuity salesmen never want to tell you or admit is that on any nominal amount of income, your taxes actually go down every year because the tax brackets are adjusted for inflation every year.

Mostly Voices [9:35]

Because only one thing counts in this life. Get them to sign on the line which is dotted.

Mostly Uncle Frank [9:39]

Usually that doesn't seem like much, although in the next year, 2023, the brackets are going to adjust about 8%, which is also something to keep in mind because in fact, the average retirees expenses and sensitivity to inflation goes down when they retire, resulting in a lower tax rate just by the math. and the adjusting brackets. This is a topic that many people get very emotional about and excited about, which is why it's used for marketing various financial products. Always be closing.

Mostly Voices [10:20]

Always be closing.

Mostly Uncle Frank [10:27]

But if you can take a dispassionate view of it, you'll make better decisions. That is the straight stuff, O Funkmaster. In the end, there's probably no wrong answer to the question you asked because just the fact that you're putting more money away means you'll have more money later whether it's in the traditional account or the Roth account and you can manage it pretty well from there.

Mostly Voices [10:48]

Groovy baby!

Mostly Uncle Frank [10:51]

So hopefully that helps a little bit. Sorry I couldn't be very much more specific and thank you for that email.

Mostly Voices [10:58]

Yada, yada, yada. Yada, yada, yada.

Mostly Uncle Frank [11:03]

Second off, we have an email from Chris and Chris writes, hello, Frank.

Mostly Mary [11:11]

It seems like there are quite a few different REIT strategies people use. For younger listeners or for listeners who don't own land, it might make more sense to tilt more towards residential and apartment REITs because those are more correlated to housing values.

Mostly Uncle Frank [11:30]

Well, Chris, I guess my first reaction is that younger investors probably don't need REITs at all. And whether they want to get involved in buying real estate directly or those kind of businesses is more up to them, depending on how much extra time they have besides their regular jobs and what level of interest they have in doing that, because it takes time and There's a learning curve. In terms of portfolio construction, I view REITs as a totally optional thing that somebody might want to consider when they get to their drawdown phase. The reason you would hold them is for a little bit of diversification. You really wouldn't expect them to perform much differently than the overall market over time, although they'll perform differently at different times. As for the categories of individual REITs or individual REITs, I would go back and listen to episodes 19 and 21 about REITs and look at the resources there, especially the link to the REIT website with all of the different categories. And if you look inside a big REIT fund like VNQ, you will see the largest ones and you can match that up with the largest ones in each category. I tend to favor things like Realty Income, Inc. Which is ticker symbol O and Public Storage, ticker symbol PSA, because they have thousands of outlets essentially or leases, which makes them very stable. Because the smaller and more specialized a REIT is, the more chances you're actually taking in terms of an investment. The only category of REITs I recommend that people not invest in are the mortgage REITs because these are more like speculative debt instruments. And so they can have performances that look more like junk bonds than anything else. If you are a younger person thinking about getting into real estate, probably the best thing you could do is look into house hacking, which is buying a dwelling as an owner and then renting out parts of it to other people because you kind of get the best of both worlds. And that's what our eldest son is doing and it's been very beneficial for his finances.

Mostly Voices [13:50]

Young America, yes sir.

Mostly Uncle Frank [13:53]

Because you can get into a property with a lower down payment but then take the advantages of rental real estate in terms of depreciation and other things you can write off on it. And your mortgage ends up being paid by somebody else. Yeah, baby, yeah! Which can jumpstart your wealth pretty quickly. A good book about that is Set for Life by Scott Trench. And check that one out if you're young and you haven't, because the best time to do that is when you're young and single and flexible. Oh, I get it. Let me try. Once you have a Spouse or family that those sorts of things become more difficult.

Mostly Voices [14:35]

Time is money, boy.

Mostly Uncle Frank [14:38]

Hopefully that helps and thank you for that email. Last off.

Mostly Mary [14:50]

Last off, we have an email from Andreas and Andreas writes. Dear Frank, podcast listener and great fan of yours from Switzerland here. What I particularly like about your podcast, apart from your sense of humor, you're doing it for charity, not for personal profit. Forget about it. Your work has been an eye-opener for me. Since 2020, I've made the whole journey from A, just having all cash in my bank account, B, investing in stock indexes, C, learning about Boglehead stock bond portfolios, and D, considering a risk parity style portfolio for my early retirement drawdown portfolio. Three things bug me about risk parity, though. Asset correlations and Sharpe ratios are not static. They fluctuate. However, risk parity strategies tend to be based on static percentage asset allocations. What if in the future past negative correlations turn positive and vice versa? Most data used for risk parity portfolios only goes back to 1970. Is there any information on how risk parity portfolios have performed looking back further in time? You often refer to the Bogle Principle of macro allocation. Risk Parity Radio episode 37 was superb. Doesn't holding small cap value in a risk parity portfolio violate that principle? And isn't holding small cap value like stock picking on an index level? After all, definitions of value vary and nobody knows if the small cap value premium will persist in the future. Thanks again for your great work, Andreas. By the way, this is a very interesting and critical article of big earn on small cap value. What do you think of it?

Mostly Uncle Frank [16:54]

All right, some interesting questions here and some of them get back to fundamental principles and episode five in particular with a link to one of the original papers from Bridgewater about risk parity investing. And that goes to your question about asset correlations and sharp ratios. Those are not really the fundamental idea or building blocks. Those are useful things to look at when you're looking at kinds of investments and looking for shortcuts in comparison. But what this actually goes back to is thinking about What macro conditions can exist in the world and how various investments perform in those macro conditions? And the macro conditions we're talking about are what is the current rate of growth in the economy and what is the current rate of inflation in the economy and how are those things moving? More importantly, how are they moving? are they increasing or decreasing? Because different asset classes have a tendency to perform differently in each of those categories. Now, as an offshoot of that, that leads you to getting correlation numbers, because obviously if they both perform or tend to perform well, say with increasing growth and increasing inflation, those two things are going to be highly correlated. I think what you need to remember is that all this tells you is a probability that a given asset in a given macro environment has a higher or lower probability of a good performance. What that also tells you is that, yes, correlations, if you look at them every day, they're going to be wildly random, just like the stock market's movements are wildly random on a very short term. the longer period you have to look at though will give you a better sense of what the average or probability is over time. And so when you're thinking about holding a portfolio for decades at a time, you need to think about what are the probabilities of various performances in various macro environments. over that kind of time period, knowing that the correlations will fluctuate through that time period. So when you ask a question, what if in the future past negative correlations turn positive and vice versa? You need to be asking yourself why. Things just don't happen for no reason. Correlations are not a random event. They are based fundamentally on this idea that different asset classes perform differently in different macro environments in a probabilistic way. So the idea that everything is going to change for no particular reason doesn't really make a lot of sense in the real world. Because in the real world there are real macroeconomic conditions. And these asset classes don't just jump around and start doing well when they weren't doing well in a certain economic condition. to begin with. So for instance, bonds are never going to do well in an inflationary environment where inflation is increasing. Stocks might not do well either, but certain parts of the stock market, namely value stocks, tend to perform better in inflationary environments than other kinds of stocks. Commodities tend to do well consistently in inflationary environments. And so there was an interesting presentation that we cited in episode 223 from Bloomberg about different asset classes and how they perform in different kinds of inflationary environments. And so you should not be looking at correlation numbers as the main characteristic of these asset classes. What we are really talking about fundamentally is how do different asset classes perform in all kinds of different macroeconomic environments and can we gather asset classes that will perform reasonably well collectively in all kinds of macroeconomic environments? Because we are assuming that we will experience all of them at some point, but we cannot predict which ones or how fast they will come or how severe a recession is going to be, for example. And the risk parity framework does assume that certain asset classes are going to have a higher probability of performing well in certain economic environments, and that basic idea is not going to change. The results you get in any particular period could be different, and the correlation numbers could be different for that period. And the Sharpe ratios are going to be different. for particular periods. But that doesn't change the fundamental idea of certain asset classes performing better or worse in given economic environments characterized by growth and inflation and the change of rates in growth and inflation. As to your question about data before 1970, is there any information on how risk parity portfolios have performed looking back further in time? Yes, and we talked about this in episode 223 as well, where we used the Early Retirement Now toolbox to run a simplified risk parity portfolio back to 1926 and showed that it had a safe withdrawal rate of about 5% for the last 90-some years. And that was without even attempting to really optimize it in any significant way. The point being that these types of portfolios do perform better than traditional portfolios when it comes to safe withdrawal rates and lower volatility over time. And now your question, doesn't holding small cap value in a risk parity portfolio violate the macro allocation principle? And I would say no, it doesn't. The main reason you're holding that in this kind of portfolio is not because you believe it's going to outperform the market in any significant way. The reason you're holding it is for diversification, that it's going to perform differently than other parts of the market in a significant way. And at different times, which will tend to smooth out the overall volatility of the stock component of your portfolio and thereby smooth out the overall volatility of the whole portfolio. and give you a higher projected safe withdrawal rate. And so there are many periods where you see small and value stocks underperforming the market, say from 2010 to 2019. And there are other periods where you see it greatly outperforming the rest of the market, say in the late 1970s, it outperformed the rest of the market by up to 15% a year on average for about eight or nine years. And this past year you've seen that small cap value has outperformed the market by 8 to 10% and large cap value has actually outperformed the market by 15 to 20%. But it really seems to be the value factor at work for years like this. So we're not really using it for the value premium or the small cap value premium. We're using it because it's well diversified and performs differently than the rest of the market at different times. To the extent we get a premium, that's just an extra added bonus. And then you cited to an article from Big Earn that we also cited in episode 223 about his thoughts on small and value stocks. And he thinks that there might not be a small cap value premium going forward. There are basically two issues with that. and I talked about this some in episode 223. You can go back and listen to that if you like. I realized your email came before that episode came out. But anyway, the two issues are first, the one I just mentioned that really the reason you're holding small cap value is this diversification component in that knowing it performs differently in certain macro environments than the rest of the market does. particularly large cap growth stocks, which are on the other end of the spectrum. The other that I can tell you is, speaking as a lawyer, this article is a very lawyerly kind of work in which you take a side and then marshal the evidence you have to support that side. If I were cross-examining him about it, there'd be some obvious problems with it. One, he makes a statement that Value did not outperform growth in the 1970s, which is false. In fact, that was one of the periods where value and small cap value in particular greatly outperformed growth from the end of the 73-74 depression or recession to 1983 or 1984. There was a great outperformance in small cap value. which makes some of the graphs in there problematic, particularly the one that starts at 1983, which basically is the endpoint of the great outperformance by small cap value in that period. I'll link to a Portfolio Visualizer analysis in the show notes, just comparing small cap value with the total market going back to 1972, and you'll see that small cap value greatly outperformed the rest of the market over that period since then, and most of it was due to this great outperformance in the 1970s. And he points, for instance, to a couple of banks that have lowered their small cap value premium. I think one of them is JP Morgan. You can go out and find plenty of outfits that have an even higher small cap value premium. For instance, if you look at these Frank Vasquez：Morningstar reports they put out in the past couple of years where they put together a portfolio and try to calculate a safe withdrawal rate. They say that the small cap value is going to outperform large cap growth by up to 50% in 2021. They said that the most recent one, they give it a outperformance of about 3% over the large cap growth. So you can find plenty of experts out there that still give small cap value a significant premium. And finally, part of it is just unfortunate timing for the article, which was written in 2019, which is after a long period of growth outperforming value. But once you get to this year, 2022, all of a sudden things have flipped again and now value is greatly outperforming growth. And that should not have happened. What we just saw this year should not have happened if the thesis of that article is correct that the premium is gone. In fact, the performance of value over growth in the past year looked a lot like it did in the late 1970s, when you also had an inflationary environment and then the Fed raising interest rates significantly. And as I mentioned in episode 223, the great weight of the evidence or the experts today supports the use of factor investing. in portfolio construction. And whether that's Merriman or Schweddy or the guys over a rational reminder or any number of others, that is really where investing is going in terms of best practices and has been going for about the past 25 years. And if you're interested and want to hear somebody wax eloquent about small cap value for the past 50 years and past 100 years, I just heard another podcast from Paul Merriman where he goes on and on about this and cites to a bunch of research they've done in tables and things like that. I will link to that in the show notes and you can check that out if you're so interested. But in the end, I view it as a diversification play for portfolio construction and not an attempt to get a premium. I will let others argue about the small cap value premium. What would you say you do here?

Mostly Voices [29:40]

Look, I already told you. I have people skills. I am good at dealing with people. Can't you understand it?

Mostly Uncle Frank [29:48]

And thank you for that email. But now I see our signal is beginning to fade. 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. 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. That would be great. Mmmkay? For all of those celebrating Christmas this weekend, have a Merry Christmas. And if not, have happy holidays. Well, have happy holidays anyway, whether you are celebrating Christmas or not. They're not gonna catch us.

Mostly Voices [30:40]

We're on a mission from God.

Mostly Uncle Frank [30:43]

We're not going anywhere, so I should have time to do a portfolio review podcast this weekend as well. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Voices [30:59]

Happy holiday, happy holiday, happy holiday while the merry bells keep ringing. Happy holiday to you. Happy holiday, happy holiday, happy holiday.

Mostly Mary [31:25]

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.