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 23 of Risk Parity Radio. Today on Risk Parity Radio, we are going to talk about how to analyze a portfolio from a macro perspective. and apply that to one that we found on the interwebs that is convenient for that analysis. But before we get to that, I'd like to give a shout out to one of my listeners, Mark, who has been emailing me about proposals for his own risk parity style portfolio. And it's very gratifying to hear from you, Mark, and to have those exchanges because what I really want for this podcast is not to give you didactic portfolios that you must follow and listen to every week to figure out how to do it, but to learn a process for it and to be able to tinker and experiment with risk parity style portfolios for yourself. And that's what Mark has been doing and is thinking about to implement for himself. Because after all we are all do-it-yourself investors and we'd like to be doing some of this ourselves. But what we really want to have is a good process for evaluating portfolios and for deciding what we are most comfortable with. So thank you for that, Mark. And now we will turn to the topic of the day. I was reading a article on MarketWatch last month and you see many of these kinds of articles and they're all kind of the same in which they say, well, the 60/40 retirement portfolio is dead or it's not going to work anymore and we need to go do something different. And now here is the new proposal of what we should do to replace the 60/40 portfolio. Just to give you some background on that, the 60/40 portfolio is a total stock, 60% total bond, 40% portfolio, and is kind of the venerable answer to everything that came out of what we call the Bronze Age of financial advising, which occurred between about 1970 and 1995, when We were first implementing modern portfolio theory, and the idea back then was to both pick stocks, pick bonds, and pick advisors to run mutual funds. As we learned as time went on, that is not an ideal strategy, and the indexing revolution took over around the year 2000. So now we are at a place where we are still referring to that 60/40 portfolio as kind of the baseline. And it is, for better or for worse, the kind of industry standard that all financial advisors look at when advising retirees. Because the idea is, if you can't beat that, you should at least just stick with that. So taking a look at this article, this article proposed that The 6040 was no longer going to work very well and you needed to look at some alternative investments. And that idea is something we do embrace here at Risk Parity Radio if it's done in a way that makes sense and according to a reasonable process. So what this article proposed, and I will link to the article in the show notes, is a portfolio that is 40% total stock market and 20% total bond market, and then taking the remaining 40% and dividing it into alternative investments. And the alternative investments that were chosen in this article were 10% in a real estate fund, 10% in a utilities fund, 10% in a high yield corporate bond fund, and 10% in convertible securities. Now, I haven't talked about convertible securities on this podcast. What those typically are are debt securities in a company that can be converted to equity. It gets more complicated than that, but we don't need to get that much more complicated right now. So what this article did, and this is interesting because this is what we can do now that you could not do back in the Bronze Age, which is pick out different asset classes and find a fund that actually represents those asset classes. Most of these ETFs just didn't exist way back when and so weren't available and weren't an option that we have now. So when you look at this, you wonder, well, that's Sounds interesting, but there wasn't really any analysis or much analysis in the article to tell you whether, well, is this better or worse than a 60/40 portfolio? And is it better or worse than one of our sample portfolios, for example? So how do you approach this? I mean, what do you do? Well, fortunately, we have tools these days, as do-it-yourself investors, that we can go to, and they're right there online. You can go to Portfolio Visualizer. and you can go to portfolio charts and you can go construct these portfolios and then compare them with other portfolios. And that is really what you should be doing either with the portfolio you have now, the portfolio your uncle is recommending, the portfolio your financial advisor insists is the best portfolio that's ever been, or whatever portfolio you are considering. The idea is not to be looking at these portfolios in kind of a vacuum and sort of, well, that feels good or sounds good or it looks diversified or sounds diversified. You really have to suspend these kind of narratives and really go and think about, well, let's put it in there and see what kind of numbers pops out if we just see what this looks like. So we went ahead and did that for the purpose of this exercise and we took this alternative portfolio and we found the ETFs that matched it. So this portfolio we constructed as 40% Vanguard Total Stock Market, 20% Vanguard Total Bond Market, and then for the alternatives we had 10% in VNQ, which is a Vanguard Real Estate Fund, 10% in XLU, which is the utilities select spider fund, 10% in HYG, which is the iShares high yield corporate bond fund or junk bonds, and then 10% in the CWB, which is the spider Bloomberg Barclays convertible securities fund. And that's a mouthful. And so that was the recommended portfolio in the article. And we took that portfolio and we matched it up with two of our portfolios. Well, we took, first of all, since they were comparing theirs to the venerable 60/40 portfolio, we made one of those, and that is 60% VTI, the Vanguard Total Stock Market, and 40% Vanguard Total Bond Market, or BND. We kept the stocks and bonds largely the same for these portfolios simply to make a more valid comparison. So any differences would not be due to say picking different stock funds for a particular period when they might have performed well. And so then the other portfolio that we picked off the shelf to compare is the Golden Ratio portfolio from our sample portfolios that you can find on the portfolios page. www.riskparadioradio.com and in that portfolio we used VTIS, the stock component, and so it's 42% Vanguard Total Stock Market, it is 26% long-term treasury bonds represented by the ETF TLT, and then it's got 16% gold in it represented by the gold fund in this analysis GLD because it has the longest data set available. And then we also used for the REITs, we used VNQ for this version because that's the same real estate fund that was suggested in the MarketWatch article. Now you'll notice that these funds are not exactly the same ones that we use in the sample portfolio, but again, because we wanted to make these more apples to apples comparisons, we took the same Funds that were identified in the MarketWatch article for comparison purposes. So we line these things all up in our portfolio visualizer analysis and our golden ratio portfolio is portfolio one, the MarketWatch portfolio is portfolio two, and the 6040 portfolio is portfolio three. And then we poke the button and let it spit out the data. and there was data for this analysis going back for the past 10 years. And what you see is these portfolios all do actually perform fairly similarly. If we look at the MarketWatch portfolio, it had a compounded annual growth rate since about 2010 of 9.85%. Now that was slightly greater than the 60/40 portfolio, which had a compounded annual growth rate of 9.53%, but it was less than the compounded annual growth rate of the Golden Ratio Portfolio, which is 10%. I should say that I forgot to mention the Golden Ratio Portfolio has 6% cash in it as the other component. If you were counting up it only went to 94 when I mentioned it before. And then we look at the other metrics here, though, and we see that the proposed MarketWatch portfolio is actually more volatile than the other two. It has a standard deviation of 9.36% compared to the 60/40, which is slightly less at 8.51%. And then the golden ratio is actually much less at 7.44%. Looking at the best years, they are 23% for the Market Watch Portfolio, 21 for the 60/40 or around 22 and 22.4 for the golden ratio. The worst years are similar. They are down about 3%, each one of them. But the max drawdowns are significantly different. The Market Watch Portfolio has a maximum drawdown in the period of 15.38%. compared with 12.29% in the 60/40, and then the golden ratio has a much less maximum drawdown of only 7.43%. And what this gets you to, as in terms of risk reward, when you put these things all together in what is called the Sharpe Ratio, and this is available on the analysis, you find that the proposal from the MarketWatch portfolio actually has a lower reward to risk sharp ratio. It's 0.99, which is less than the 60/40, which comes in at 1.05 and significantly less than the Golden Ratio Portfolio, which comes in at 1.25. And what that is telling you is that the proposed portfolio, from a risk reward perspective, really isn't any better than the 60/40 and is significantly less good than the golden ratio. And so that really gives you a macro perspective that it is not sufficient simply to take these alternatives and sort of just throw them in the bucket and see what happens. That what's important is you put them together and you analyze them together. If you analyze them separately, you may find out different things or things that don't work when you put them together. So you have to put them all together and run this kind of analysis to see really what you're looking at in terms of a portfolio. One of the things I thought was interesting about this sample Market Watch portfolio was that it actually had a better performance than the other ones in the last three months. So it was kind of a recent winner, but Over time, the performance was just not as good over either the year to date, 1-3-5-10 or full that this was something that works well recently, basically. And so in that three month comparison, you do see the MarketWatch portfolio at 6.41% compared with the 60/40 at 5.5. and the golden ratio at 4.67%. And then if we just look at a couple other metrics here for completeness sake, we see that the monthly standard deviation or volatility for these portfolios again is highest for the proposed Market Watch portfolio at 2.7 compared with 2.46 for the 60/40 and 2.15 for the golden ratio. and that also translates over if you look at the projected perpetual withdrawal rate. Now this is based on only the 10 years of data, so take it only for comparison purposes. But you do see that the 6040 was at 7. 63% for this data set. The proposed Market Watch portfolio is 7.91% and that is less than the Golden Ratio, which is at 8.05%. Now then this gets us to the question of why this portfolio is a little bit better than the 60/40 in some respects, is a little bit worse in other respects, and is not as good as the Golden Ratio portfolio. And usually when you're talking about standard deviations and you're talking about drawdowns, it all goes back to the idea of diversification. Now, is this portfolio really as diversified as some of the other ones? You would think maybe that it is based on the names of the funds. I mean, convertible securities sounds completely diversified, doesn't it? It's different, isn't it? High yield bonds, maybe that's different. Utilities sounds different than the other. Real estate sounds different than the other. And there are some differences in here, but in order to evaluate whether there is diversification between any two asset classes, you can't just look at the name. And that's the problem that we have as do-it-yourself investors, that what we read, what is suggested to us, is that, well, this has a different name, it must be different, it must be diversified. because it's different in some way than the other thing. Unfortunately, that is not the way to evaluate diversification. In order to evaluate diversification, you need to go look at the correlations between the assets using whatever data you have to rely upon. And fortunately, we have those tools at our disposal and we went and ran a Asset correlation analysis for this proposed market watch portfolio over at Portfolio Visualizer. And we will link again to that in the show notes. And when you look at this and you see the stock fund, which is the 40% component, and so you're most interested is are these other components diversified from that? and you see that the total bond fund is uncorrelated. It has a correlation coefficient of -0.06%, so about zero, which means it's uncorrelated, not negatively correlated. And the utilities sector fund actually has a low correlation of 0.38 to the total stock market fund. But then you look at some of these other things, that convertible securities ETF, CWB, has a correlation of 0.91 with the total stock market. So that's really not diversified. 0.91 is similar to another stock fund. So the way this is actually performing, as if it's just like another stock fund in there, it's not really giving you any diversification. If you look at the Vanguard Real Estate Fund, that's a bit better. It's at positive 0.69 correlation, which isn't bad for something different. And then you look at this high yield bond fund. Now, you would think that bonds would be diversified from stocks, but as we talked about in our bond episodes, some bonds are not diversified from stocks. And this is one of those funds, HYG, high yield corporate debt or junk bonds. are very highly correlated with stocks. And so the correlation coefficient here is 0.77. So really that is not a very helpful thing to put in a portfolio that is driven mostly by stocks because you're not getting any diversification out of it. Now, unfortunately, the article proponents did not talk about these components as if they were really diversified. There was an assumption that because they were different, they were diversified. And that is the assumption that we need to really excise from our thinking when we are thinking about portfolio construction. Because that ultimately, I can tell you, is the problem with this portfolio, that these alternatives that they chose really aren't very well diversified. from the stock market and so really aren't giving you the kind of diversification that you would want to reduce that standard deviation, reduce that volatility, and increase the potential drawdowns for the portfolio. And that really concludes this for that analysis of that portfolio. and you shouldn't be saying, well gosh, that's a terrible thing. You know, actually it was kind of a good try, but the problem is you try, but you need to analyze what you're trying, and I would invite you to take whatever portfolio that you are currently thinking of using in your retirement, or had been proposed to you by a financial advisor or somebody else, and analyze it yourself. Go ahead and stick it in there. It should at least perform as well as the 60/40 portfolio or you're just kind of wasting your time making something more complicated than it needs to be and not getting anything out of it and that violates what we call the simplicity principle that if you're going to make something more complicated you would want to see some benefit from that complication and we really don't see a whole lot of benefit from that complication in this case. But the other thing you should be mindful of, and I don't want to turn this into a rant at this point in time, but often these proposals are basically used as scare tactics to sell you things. And you'll often hear that the conventional wisdom is that there are problems with the 60/40 portfolio and the 60/40 portfolio Isn't going to work. So we need an alternative. Unfortunately, a lot of times the alternatives that are proposed are expensive and maybe counterproductive and often include annuities, insurance products and other strange contractual things with bells and whistles that while they sound good on their surface really don't stand a close examination. due to the drawbacks in terms of both reducing your flexibility and reducing your returns overall because somebody's got to pay that piper if you're talking about a much more complicated financial product that you're trying to stick in here. Fortunately, we don't have to rely on that. That is not that is all on the menu. We have a large selection of ETFs in virtually any kind of alternative investment we can think of these days. And while that seems kind of daunting, it is actually not so bad to take a few of those things that people have proposed and put them in these little analyses, see how they're correlated or not, to whatever else you have in your portfolio. and see how they might have performed in the past and might perform in the future in terms of relative performance to other things that you might be invested in. But with that, I see our signal is beginning to fade. We will pick up this weekend again with our portfolio review and we will have a portfolio of the week the aggressive 5050 that we will compare to a couple of Dave Ramsey style portfolios. And if you'd like to contact me, email me with your questions or concerns or anything else, you can do that at frank@riskparityradio.com that's frank@riskparityradio.com or go to the website www.riskparityradio.com and fill out the little form and I will get your message and I will probably respond to it. Thank you for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [24:06]

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.