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 [0:21]

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 [0:40]

Thank you, Mary, and welcome to episode three of Risk Parity Radio. Today's episode is the first of a two-part episode about the history of risk parity style investing. What you will learn is that although the term risk parity did not come into being until the 1990s, The ideas behind it are very old. They're very old indeed. We have three questions today, just three. First, how far back in time do ideas about asset allocations go? Second, what was discovered in the 1950s and what did that lead to? Third, how did the experience of the 1970s change some people's thinking? First question, numero uno. How far back in time do ideas about investing in asset allocations go? The answer is we're not quite sure. But we do know that it's not decades or centuries, but in the thousands of years. Some investment firms look back to ancient China and the teachings of Confucius. He advised to invest early, Invest wisely, invest flexibly, invest patiently, and invest with the right tools. Basically what he was saying was to get started as soon as you can, invest carefully in a variety of things, plan to hold them for a long time, and always use the best information available. But that's pretty vague in terms of asset allocations. Others have found evidence that the standard portfolio in ancient times consisted of three basic asset classes. If we look in the Talmud, which are the books of wisdom and law prepared by the Jewish rabbis during the first few centuries of the common era, we'll find a tract called the Baba Metzia, or Middle Gate, which is mostly about property law and lending money. In verse 42：8 we find a passage that states, A man should always keep his wealth in three forms：one-third in land, one-third in business, and one-third at hand. And thus we have what has become known as the Talmudic portfolio. The one-third in land was supposed to be stable but have a low return. The one-third in business is higher risk and higher return. And the one-third at hand was there for exigencies and opportunities. This was not really a new idea at the time, but a sort of conventional wisdom that had been handed down. Over the centuries, people have interpreted this in various ways. One-third in land usually means an investment in rental real estate, or REITs, in modern finance. It could also mean agricultural land. One-third in a business could be a personal business or an investment in the stock market. And one-third at hand originally meant silver or gold, but now could also include cash and safe bonds depending on who you talk to. And so you can find various formulations of this Talmudic portfolio on the internet if you search for it. When we get to the Renaissance and up into the 19th century, you see other formulations of this triapartite portfolio. You might be thinking of the Damedicis or other families known to preserve wealth through generations. And so what was the secret there? Typically the wealth itself was generated through some kind of a business Perhaps a trading business or a banking business or even an inheritance of some kind. But to preserve it for generations, the family would invest in three things：land, gold, and fine art. The advantage that gold and fine art had is that they were portable. Because you never knew who was coming to power next and what they might do. And they could take your land, but you could always leave. with your gold and your fine art. And there were no real stock exchanges to invest in. Corporations were a very rare sort of entity and they had to be created by special charters from the government. So the whole landscape of how you could invest was completely different. Second question, numero dos. What was discovered in the 1950s and what did that lead to? So let's fast forward to the 1950s. By that time, financial markets and stocks and bonds were very well established for over hundreds of years. In the early 1950s, Harry Markowitz formulated what is now known as modern portfolio theory, and he won a Nobel Prize for that in the 1990s. Basically, he took the idea that owning diverse investments could be a virtue in minimizing risk versus reward, and then formalize that idea with mathematics. But he was applying this first just to the stock market or a set of generic tradeable financial assets. Stocks and bonds were what he was thinking about here really. What he showed was that by holding a sufficient number of these types of assets and in specific mathematical proportions, one could reduce the overall risk for the reward gained. Now implementing this theory in practice turned out to be very difficult. One of the main problems is that it assumed that the risks and returns for each component were more or less predictable, which is really not the case. So the main problem turns out to be not having enough data. Statistically, you would actually need something like 500 years worth of data if you were going to try to apply modern portfolio theory to all of the stocks in the market to determine what proportions you should hold them in. So it's not practical if performed to the nth degree. But people did find ways to apply it and use more simplified versions of it. It's interesting that Markowitz himself employs a very simplified strategy, which is called 1 over N. which is equal weight investing. Essentially what he does is he's got, say, 10 things he wants to invest in. He'll simply divide his resources into 10 and invest 10% in each. Sounds awfully simple for somebody that won a Nobel Prize, but sometimes having a rule of thumb works much better in the real world than a complicated theory. For our purposes, the main idea that came out of modern portfolio theory in the 1960s was to look at portfolios of just stocks and bonds and determine what proportions to hold them in. And so Markowitz and others came up with graphs showing what is known as the efficient frontier for coming up with the right mix of stocks and bonds for a given level of risk. And so out of that research came to be what we know today as the 60/40 portfolio, which is 60% stocks and 40% bonds. And usually the type of stocks we're talking about basically cover the entire market with an emphasis on larger cap or blue chip stocks. And the 40% bonds in the portfolio are usually high grade treasury bonds and high grade corporate bonds. Now this portfolio was found to be many to be close enough to the best risk reward mix one could achieve for long haul investing for retirees. And so when the financial planning industry really got off the ground in about 1970, this is the kind of portfolio that advisors tended to gravitate towards when they weren't fiddling around with tax shelters, which was actually the really big business in the area before 1986. And so that portfolio, the 60/40 portfolio, came to be recognized as the baseline to which all retirement portfolios should be compared. That if you couldn't at least do that well, there wasn't any point of deviating from the simplicity of the 60/40. Third question, numero trace. How did the investing experience in the 1970s change some people's thinking? The 1970s were a really bad decade for both stocks and bonds. Stocks went up and down, but really went nowhere overall, if you looked at them for the entire decade. Long-term bonds did even worse, if you looked at those and accounted for inflation. So if you were holding a 60/40 portfolio or a 50/50 portfolio or basically any combination of stocks and high grade bonds, you probably didn't do very well in the 1970s. If you had invested in a 60/40 portfolio in 1973, your portfolio would have been underwater for a decade. And that was not very satisfying to a lot of people. So what did do well in the 1970s? Well, money market funds did well. Money market funds were invented in 1971 and gave ordinary investors an easy way of investing their cash in really short-term debt. So whenever interest rates went up, the money market rate followed it up in short order. And so by the end of the 1970s, you could make 12% or 13% in the money market. And those rates peaked at about 15% in the early 1980s, given what you could get just for putting your cash in that, it seemed like almost foolhardy to invest in the stock market at the time. So what else did well in the 70s? Gold did really well. It became legal for US citizens to own gold again at the end of 1974. And then the price of gold went from about $35 an ounce in the early 70s, before that, to over $800 announced by the end of the decade, after which of course the price crashed. But the 70s were very good to gold. Now commodities also did very well. The price of everything was going up. This became a hot area for speculators and investment firms. People like Ray Dalio, who were coming up the ranks, found themselves specializing in things like cattle futures and other agricultural commodities. Real estate also did pretty well. The price of land went up in most places, whether it was residential or farmland. At least kept pace with the inflation at the time. And so by the end of the 1970s, people began proposing portfolios that went outside of just stocks and bonds. A number of these people were outside over on the fringes of the retail financial industry, which was still mostly focused on giving people hot stock tips and helping them find tax shelters. One of those people was a guy named Harry Brown, who's actually most famous for writing a book called How I Found Freedom in an Unfree World, which was his modern take on Emerson and Thoreau. It was not an investing book, but more of a personal libertarian manifesto. In 1977, he came up with a portfolio that harkened back to the earlier times we talked about in answer to question one. and he called this the permanent portfolio. The permanent portfolio was comprised of four asset classes：25% stocks, 25% long-term treasuries, 25% gold, and 25% cash and money market funds. And of course it did quite well at that point in time. Now I have one of his books on my shelf from 1987. It's called why the Best-Laid Investment Plans Usually Go Wrong. and how you can find safety and profit in an uncertain world. It's a long title. It's out of print. It's kind of funny to read it because it shows how much more difficult it was to be a do-it-yourself investor back in that time period before we had these exchange traded funds and commissions were low and you had to buy physical gold, for instance, and figure out where to store it. So this covers his basic thesis, which was to hold different asset classes for different economic conditions. And the way he explains it, he picked stocks for times of general prosperity, gold for times of inflation, long-term treasury bonds for times of deflation, and cash when nothing else is doing very well. Now his idea was that you wanted to have volatility that moved in different directions. So that one or two of the asset classes was going down in value, the others would be going up in value, or at least not losing money. And then you could sell your winners and buy more of the losers, which is what we know today as simple rebalancing. And he thought that the safe withdrawal rate from such a portfolio would be around 5% annually. which actually was a pretty good guess looking back 50 years from today that people have put this thing through the ringer and 5% is about what it comes out with. He also created a more complex permanent portfolio mutual fund that included investments in Swiss francs and natural resources and real estate and silver. Now, as it turns out, this permanent portfolio was a good stab at the problem, but it had its own internal problems. First of all, it was not really balanced by risk or volatility. Just dividing it up into 25% each way didn't really make that much sense. It turns out that gold is a lot more volatile than stocks. Stocks are more volatile than bonds, and everything's more volatile than the cash. So the overall portfolio was too dependent on the performance of gold. When gold did well, like in the 1970s, this permanent portfolio shined. When it did poorly, like in the 1980s, the portfolio underperformed by a lot. So it quickly fell out of favor in the 1980s and really didn't become popular again until the 2000s, when gold began to perform well again and the stock market started having trouble. Second, Brown's thinking was a little fuzzy on how to define economic conditions in a more systematic way. So something like gold actually was not always the best inflation hedge. And sometimes it did well during deflation, for example, which he really couldn't explain and didn't have the data for at the time. And stocks could actually be a decent head during inflation if there was also growth in the economy. And holding 25% of your assets in cash was a bit excessive, especially when interest rates began to get down to historical norms and then have gone even lower over time. And so that idea has not really held up the test of time. As it turns out, there were better ways to approach this problem that involved looking at changes in growth rates and looking at changes in rates of inflation. and using more asset classes and diversifying them in different proportions so that their volatility and risk profiles tended to match each other a bit better. But now I see our signal is beginning to fade, so I'll ask you to tune in next time, which should be this Sunday, for a weekly portfolio review. And then in two episodes we'll come back to part two of the history of risk parity portfolios to explore what happened in the 1990s to really set off the risk parity revolution and then how it has evolved since then. Thank you for joining me today. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [17:34]

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.