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.

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 foundational episodes for this program. Yeah, baby, yeah! And the basic foundational episodes are episodes 1, 3, 5, 7, and 9. Some of our listeners, including Karen and Chris, have identified additional episodes that you may consider foundational. And those are episodes 12, 14, 16, 19, 21, 56, 82, and 184. And you probably should check those out too because we have the finest podcast audience available.

Mostly Mary [1:28]

Top drawer, really top drawer, along with a host

Mostly Uncle Frank [1:32]

named after a hot dog. Lighten up, Francis. But now onward, episode 263. Today on Risk Parity Radio, we're just going to keep hacking away at these emails from April. Geez. But before we get to that, I just wanted to alert you to a new podcast that I have recently discovered. It is called the Security Analysis Podcast, and it is by the Value Stock Geek, whom we have heard from on this podcast. And in particular, he has a nice interview of Tyler from Portfolio Charts in his last episode that I think most of you would enjoy listening to. Because it covers many of the themes that we talk about here. I will link to that in the show notes and you can check it out.

Mostly Voices [2:27]

Yes! But now without further ado... Here I go once again with the email. And... First off.

Mostly Uncle Frank [2:38]

First off we have an email from RJ.

Mostly Voices [2:42]

Or you can call me Jay, or you can call me RJ, or you can call me RJJ, or you can call me RJJ Jr.

Mostly Uncle Frank [2:50]

And RJ writes, Dear Frank,

Mostly Mary [2:54]

appreciate your show very much since I started listening more than two years ago. I would love to hear your opinion about the fairness of the discount rate I use for my own retirement planning. First of all, I budget in real terms. For instance, let's say my living costs stay the same over my life. Example, $40,000 US dollars per year. Then I can use this amount at any point in time and do not need to inflate it. Then multiplying with 25 to get a retirement amount of $1 million US dollars, which is in today's value, and knowing that this amount in nominal terms would rise with inflation over the years, I adjust the discount rate for inflation, 2%. Also, assume I need to pay constant tax of 30% on gains. I expect a nominal rate of return of about 8.5%, then do the adjustments above to get 3.9%. The number of years it takes to double an investment in real terms is about 18 years, which is much more than the 8.5 years it takes to double with just the nominal rate. I think budgeting using after-tax real terms makes the numbers easier to understand. What do you think about the method and using the 8.5% as basis? A thousand thanks for all your efforts with the show.

Mostly Uncle Frank [4:12]

First, let me clarify that RJ appears to be from somewhere in northern Germany or Denmark based on his last name, which I will not make public because I don't make last names public typically. So we went with RJ because of his first initial is R, and we don't have the rest of his first name.

Mostly Voices [4:37]

And a nickel get your hot cup a jack squat. Anyway, getting to your question, RJ.

Mostly Uncle Frank [4:48]

What you have done here is very common amongst amateur investors trying to do these sorts of calculations and projections. And what you have done is count inflation twice, essentially. You are correct that it is much easier to do these sorts of calculations if you use real rates of return, which have already been adjusted for inflation, because as you observe, then you only need to be talking about today's dollars for everything. And there is an assumption that today's dollars will be less than tomorrow's dollars due to inflation. Now, where did you count inflation twice? This is how you did it. you used the figure of 8.5% as the return for, I guess, the total stock market. But historically, that is actually the inflation-adjusted return for the total stock market. It's around 8%. The nominal rate for the total stock market, at least the US stock market, is 10 to 11% over at least the past 100 years or so. And so in order to vary from that, you would have to be using a crystal ball that said that Future returns were going to be significantly different than past returns.

Mostly Voices [6:03]

A crystal ball can help you. It can guide you.

Mostly Uncle Frank [6:06]

And so the only way you would get to 8.5% as a nominal rate is by use of a crystal ball. A really big one here, which is huge.

Mostly Voices [6:18]

So you would not make a further inflation adjustment

Mostly Uncle Frank [6:22]

to that return. You would not substract 2% from a return that is a real return that has already been inflation adjusted. Either you use the nominal rate and make an inflation adjustment, or you use a real rate and do not make an inflation adjustment. And this is where people screw this up all the time. They go, I'm gonna be conservative and take an 8.5% or 8% rate of return for this stock market. And then I'm going to subtract inflation from that and get to 5%. And guess what? If you're that conservative, go buy yourself some annuities because that is what you're actually forecasting, that the future markets are going to be so abysmally worse than the previous hundred years that you'd be better off buying contracts instead of investing. Human sacrifice, dogs and cats living together, mass hysteria. Or you can just use the nominal rates and then add an inflation adjustment. So if you look at, say, for instance, what Morningstar did in its last report, it did some projections and came up with nominal rates at between 9% and 12% for various sub-asset classes of the stock market and then applied an inflation rate to that. I think it's much easier to simply use historical real rates of return. which are already incorporating inflation, and then do not add another inflation adjustment to that. All right, the other thing you did was assume a constant tax of 30% on gains. I don't know what things are like in the country you're in, but that certainly would not be by any way shape, means, or form an appropriate adjustment to make in the US or in most countries. you are not paying 30% on the value of your portfolio in taxes every year. In fact, you could be paying nothing if you're not selling anything or if you tax loss harvest. And in the US, your capital gains should be 15% or 20% or even 0% for some people. But those only occur when a sale occurs. and they are not applied to your entire portfolio. They are only applied to the proportion that is sold. So I don't think that tax assumption makes any sense either. Forget about it.

Mostly Voices [8:47]

So I'm sorry to say, I think you're just going to have to put this

Mostly Uncle Frank [8:50]

methodology aside because I don't think it's appropriate or useful for you. That's not how it works.

Mostly Mary [8:57]

That's not how any of this works.

Mostly Uncle Frank [9:01]

What you might do, although I can't say that it has the data for Europe in it, is use the Monte Carlo simulation over at Portfolio Visualizer, which allows you to use historicals for that purpose. Or if you wanted to actually put in your own numbers, you can put in your assumed rate of return and assumed standard deviation and run the Monte Carlo simulation with those parameters as well. and you can inflation adjust it or not. But the reason you want to do it that way is because you want to get a range of outcomes. You should never be assuming a constant rate of return for any simulation unless you are dealing with a contractual instrument or a bond. Once you have something that has a variable rate of return, like a portfolio based on the stock market, then you do either need to use randomized historical data or choose a median rate of return and be putting in a standard deviation into the calculation and then doing a calculation off of that. But I do thank you for bringing this to our attention because I do see this as a very common error in people trying to make projections. Is to mix and match nominal returns for things and real returns for things and then add inappropriate other measures such as the taxation issue that we talked about. And if you take estimates, your inputs and make them overly conservative or make your inputs overly aggressive, what you are going to get out of your calculation is always going to be garbage because it will compound your overly conservative or overly aggressive assumption. This is why you want to use the most realistic assumptions that you can come up with. And unless you know better, unless you have a crystal ball, the most reasonable assumptions you can use are long-term historical data for just about anything. Now, the crystal ball has been used since ancient times. It's used for scrying. healing, and meditation. So you want to start with the most reasonable assumption you can make, run your simulations, get a range of outcomes, and then if you are being conservative or aggressive, look at the outer edges of that range of outcomes as the conservative or aggressive output, not something that has compounded inputs in it. You need somebody watching your back at all times. Hopefully that helps. And thank you for your email.

Mostly Voices [11:55]

Bow to your sensei. Bow to your sensei. Second off, we have an email from Mark. All hail the commander of his majesty's Roman legions. The brave and noble Marcus Vindictus.

Mostly Mary [12:18]

And Mark writes：hi Frank, I found some comments on low beta tilts by Professor Campbell in a recent Rational Reminder podcast intriguing. Specifically, he suggests retirees should consider tilting to low beta stocks and out of cash to obtain similar returns with less volatility and smaller drawdowns. A simple backtest confirms this, referenced below. I'm particularly drawn to low beta tilts like utilities and consumer staples because it maintains equity-like returns with much improved drawdowns. I feel drawdowns are a more appropriate measure of the risk in retirement portfolios than just straight volatility, especially so in early retirement. Beyond drawdown improvements, low beta helps elsewhere. As far as equity tilts go, low beta has the added bonus of one, much less correlated to equities than small cap value, approximately 0.6 versus approximately 0.9. Two, held up better in most bear markets, see research attached. And three, they are pretty valuey per Morningstar, and it helps tilt the overall portfolio to value exposure. And of course, you can build a portfolio with both low beta and small cap value. Minimizing drawdowns, say one year, is an aspect of portfolio design you haven't touched on much. So any thoughts on how to design an overall portfolio to better improve this are appreciated. Similarly, your thoughts on low beta tilt would also be illuminating. Thanks for all you do. I benefit enormously from your nonsensical ravings, Mark.

Mostly Voices [13:57]

I am a scientist, not a philosopher. Hearts and kidneys are tinker toys.

Mostly Uncle Frank [14:03]

Well, yes, I did listen to that interview of Professor Campbell, and I do also find low beta funds to be quite interesting. I will be linking to the Rational Reminder episode, your correlation analysis, and your back test in the show notes so people can check those out. But here's the thing. You don't need to construct low beta out of things like utilities and consumer staples. You can. But these days we actually have low beta funds. And the most popular ones these days are USMV, which we've incorporated into some of our sample portfolios, and another one called SPLV. And both of those are essentially indexes of low beta stocks that adjust periodically. over the course of a year. They have different adjustment mechanisms. The problem that we've had, or at least that I've had, is modeling these things long term is difficult because a purely low beta ETF or fund has not been around that long and I'm not aware of any long term index that you can use to model such things. The closest you would be able to come to with Basic factor modeling is something like a combination between large and mid cap value. So these funds that we have have only been around since about 2010 or 2011. I did stick one into your simulation, which I will be linking to in the show notes. And you can see that the new portfolio I constructed where I took the allocations to Utilities and consumer staples and put them into USMV performed slightly worse than those did over the past 12 years, I guess it is, but better than your portfolio one. So it was between the two portfolios. Unfortunately, that period is not a good period for low beta stocks. That period, mostly the 2010s, was a very good period for high beta stocks, namely growth stocks. So it's hard to conclude anything out of that. Another interesting fund that we've talked about in the past is called BTAL, and we talked about that in episode 114. And that is an interesting fund because it is a long-short fund, but it's long low beta stocks and short high beta stocks. So it tends to go up when the stock market is going down, or when value stocks are greatly outperforming growth stocks, both of which occurred last year, so it had a good year in 2022. In fact, it was up over 20% in 2022, although it was down over 6% this year, as you can imagine, since growth stocks are outperforming value stocks again. But that fund may be another way to add some insurance to a portfolio and also tilt it a little bit more towards low beta stocks to the extent you're looking for that. Now, as for minimizing drawdowns, yes, there are two factors to doing that. One is minimizing the depth of the drawdown, and the other is minimizing the length of the drawdown. And these style of portfolios are designed to do a bit of both, and that's a product of both. Diversifying the stock portion to include low beta and value oriented stocks. And then also diversification to other asset classes. But that is a basic characteristic of what we are trying to achieve. You do need to have a balance of both of them because obviously if you only focus on minimum drawdowns, then you are just getting a very low return investment like cash. Forget about it.

Mostly Voices [18:00]

But that certainly is one of the primary factors that leads

Mostly Uncle Frank [18:04]

to a higher safe withdrawal rate of a portfolio overall.

Mostly Voices [18:08]

That is the straight stuff, O Funk Master. And so thank you very much for your email. Class is dismissed. Last off.

Mostly Uncle Frank [18:28]

Last off, we have an email from Jaako from Finland.

Mostly Mary [19:13]

And when Jaako is done singing along with Finland's entry into Eurovision 2023, Jaako writes：hello Frank, what do you think of this ETF for hedging inflation? Even though your excellent podcast seems to be catching international attention, I naturally don't expect you to know European products, but there might be something similar in US markets. Best regards, Jaako from Finland.

Mostly Uncle Frank [19:34]

Well, Jaako, as you surmised, no, I am not familiar with this particular fund, which is called the Lyxor EUR 2 to 10 year inflation expectations UCITS ETF, and I will link to that in the show notes so you can check that out. But it basically invests in a long short operation involving French and German bonds to try to take advantage of increasing inflation expectations. It was more complicated than I thought, so there's really No explanation I can give to you on a podcast that would make sense other than to direct you to take a look at what they're doing over there. But there are products in the US that at least try to do these sorts of things. One of them is IVOL, which unfortunately did not do so well last year. It has a sister fund called BND, that's supposed to deal with deflation. And both of those are also based on the shape of the yield curve, as is this fund that you're talking about. Ones that seem to do actually better in terms of inflation and inflation expectations in the US are RRHRSR and PFIX, which had a bang up year last year, was up about 60%, but is highly sensitive to inflation. and inflation expectations. So I'm not sure that using something that is trying to deal with changes in the yield curve is necessarily the best idea for dealing with inflation. I think one of these other funds that I mentioned in the US does a better job of it. But all of these funds have different formulations. We did talk about IVOL here back in episodes 70 and 72. And then in episodes 197 and episode 237, we talked about RISR and RRH. And even Triple H and the big shell in a spin swapping make out match. And we talked about PFIX in episode 248. But if I were trying to hedge inflation specifically, I'd probably use PFIX. or RRH or RISR in some formulation and would not use something like IVOL or something that was purely trying to deal with changes in the yield curve itself. Not going to do it.

Mostly Voices [22:15]

Wouldn't be prudent at this juncture.

Mostly Uncle Frank [22:18]

But your mileage may vary and thank you for your email.

Mostly Voices [22:37]

But now I see our signal is beginning to fade.

Mostly Uncle Frank [22:44]

Since we'll be out of May pretty soon, we will actually be doing a podcast this weekend where we will have our weekly and monthly portfolio reviews to go over, as well as some more emails that we need to catch up on here. 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 of review. A follow. That would be great. Okay. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Voices [24:06]

The Risk Parity Radio show is hosted by Frank Vasquez.

Mostly Mary [24:10]

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.