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 episode 32 of Risk Parity Radio. It is time for our weekly portfolio review of the sample portfolios you can find at www.riskparityradio.com on the portfolios page. We will also be discussing the topic of rebalancing today because one of our sample portfolios has hit a rebalancing trigger. That is the aggressive 50/50. We'll be looking at that in more detail after the initial review. Taking a look at the markets this week, the S&P 500 was up 2.16%. Nasdaq was down 0.53% or 5.5%, excuse me. Gold was down 3.24%. Long-term treasury bonds represented by the ETF TLT were down 0.67%. And REITs, one of our components of some of our portfolios represented by R E E T, the ETF, were up a whopping 8.6% this past week. It was one of those unusual weeks with lots of stuff moving around, but this all translated into a pretty calm week for our Risk Parity Style portfolios, which all advanced a little bit in the kind of manner we would like to see them move slowly upward all the time or most of the time. So going to the portfolios, we'll start with the All Seasons portfolio. This is our most conservative sample portfolio. It has only 30% invested in the stock market and most of it is in bonds. It was up 0.26% last week and it is up 1.2% since inception in July. And then we'll go to our next portfolio, which is one of our kind of baseline portfolios that you might actually use in a drawdown scenario in retirement. And this one is the Golden Butterfly. This one is the one that is 20% long-term treasuries, 20% short-term treasuries, 20% gold, and then 40% in stocks divided into the total stock market fund, VTI, and a small cap value fund, VIOV. This one was up 1.67% last week and is up 7.06% since July at its inception. Moving to the next portfolio, it is the golden ratio portfolio. similar to the last one, but it has 42% in stocks divided into three funds, VUG, a large cap growth fund, VIOV, a small cap value fund, both from Vanguard, and USMV, which is a low volatility fund that tracks the S&P 500 index. It also has 26% in long-term Treasuries represented by the ETF TLT, 16% in gold represented by GLDM, the ETF, and 10% in REITs represented by R E E T, which is the one that was up 8% last week. And it also has 6% in cash. So this one was up 1.99%, almost 2% last week, and is up 7.13% since inception in July. And now we move to our most complicated portfolio, the Risk Parity Ultimate. I will not go through all of the funds in this, there are 12 of them, but it is roughly 40% in stocks, 25% in long-term bonds, 15% Excuse me, it's 10% in gold, 10% in REITs, and 12.5% in preferred shares. And then it has a very small component, 2.5%, in a volatility index fund. So this one had a good week. It was up 2.03% and it is up 5.79% since July. It was a good week for alternative investments and so you can see why this one, which is usually less volatile than the golden ratio or butterfly had a better week than they did this time around. Now we're going to our two experimental portfolios which are much more volatile and are comparable to a total stock market portfolio. First one is the Accelerated Permanent Portfolio, and this one is 25% UPRO, the leveraged ETF that tracks the S&P 500 times three. The leveraged bond fund is TMF with similar characteristics, and that's 27.5% allocation of that. And then we have 25% allocated to PFF, the preferred stock fund, and GLDM, the gold fund, which is 22.5% of this portfolio. So it was up just 1% last week, and so it is up 7% since inception in July. And now we move to our last portfolio, another experimental portfolio, and this is the one that is going to be rebalanced. on Monday. It is called the aggressive 50/50 and it is 33% in the leveraged stock fund, UPRO, 33% in the leveraged treasury bond fund, TMF, and then 17% in a intermediate treasury bond fund called VGIT from Vanguard and 17% in a preferred stock fund called PFF. and that was up 2.22% last week. It is up 7.27% since inception in July. But now let's talk about rebalancing because this portfolio hit a rebalancing band this week. The topic of rebalancing, and we'll talk about the topic first and then get to the fund, is one that is kind of neglected a lot by the financial industry, although there are a number of good articles out there about it. The concept here is that portfolios start with a set allocation, but then over time they will vary from that set allocation or the allocations in them of the various components simply because different components will outperform other components over any given period of time. And the question then becomes, well, when do you rebalance that? When do you put it back to its original configuration? And there are several different types of rules that have been come up with. The most common is the time-based rule or calendar-based rule, which basically says, let's just rebalance this based on the calendar. Usually one year is taken as the baseline that somebody would rebalance a portfolio on. Others have used one month rebalancing or a quarterly rebalancing or a twice a year rebalancing. Recently, William Bengen, who invented the 4% rule, suggested that perhaps even longer than a year would probably be a better rebalancing period to use. I'm going to link to a article in the show notes from Michael Kitces about rebalancing and he quotes a study there where they looked at simple stock bond portfolios going back to 1926 and determined that there was no real advantage to rebalancing more frequently than one year. That monthly or quarterly rebalancing really didn't add much. And the problem than you have with that is the churning or transaction fees or taxes that may be generated out of those events. So it appears that it doesn't really make sense if you're going to use a calendar to be rebalancing more than once a year. Now I should caveat that though because these analyses were based on these simple kind of 60/40 stock bond type portfolios or 50/50. And it's rather the case if you look at individual portfolios with different types of allocations they're going to potentially have different rebalancing characteristics or a desirability of rebalancing at different periods or in different ways. And so to get around that, what the financial advisors have come up with are the alternative of using tolerance bands to decide when to rebalance. Now, a tolerance band is simply taking a look at your portfolio periodically and seeing if it's gone so far out of whack that's the time to rebalance. So for instance, if you had a 50/50 stock bond portfolio say, you could set your rebalancing bands at 60 or 40. So if the stock or bond, well they're going to go the opposite way since there's only two components there, but if they go to a 60/40 setup from their 50/50, you would say that the the band has been triggered or violated and then you would rebalance to the 50/50. There are now two ways to look at that though. You can look at it as should we do it sort of an absolute percentage? So we're going from And I'll use our portfolios that we've got that we're going to talk about rebalancing here, the aggressive 50/50. Now that one is 33% in this stock fund, 33% in this bond fund, and then 17% in a intermediate treasury bond fund and 17% in a preferred stock fund. Now you can look at the rebalancing of that in two different ways and we're using bands for that. so you could look at an absolute number away from the original percentage. So in our case, we're using 7.5% and so 7.5% from 33 is 40.5 or going the other direction would be 25. 5 and that could trigger a rebalancing. The other way to look at this is to use a relative scales and oftentimes the number used is 20% and that number comes up as seemingly optimal in this article that I'm going to go to. But 20% of the 33% would be 6.6% absolute. So that would take you you would go 6.6% up or down from the from the 33, excuse me. If you're looking at one of those components that was only 17%, you could use, if you use the absolute number, 7.5%, that'd be a lot from 17%, that would be 25, four and a half, or nine and a half. But if you looked at that from a relative standpoint, as in what if they're just 20% off, Then you're only talking about having one of them to move 3. 4% to get to you for a trigger for rebalancing. Now, of course, you know, talking about all this is one thing, but trying to figure out, well, what is the optimal rebalancing strategy for a particular portfolio? The answer is we're not sure because each different type of portfolio is going to have a different best rebalancing band. So you're stuck using rules of thumb, really. You can go to the Analyzers at Portfolio Visualizer and fiddle around with different types of rebalancing either by time or by setting percentages on rebalancing bands. But eventually you get to a problem in data science or Statistics, which is known as the bias variance dilemma. And what that means, sort of to get to esoteric here, but what that refers to is overfitting of data, that if you find the optimal parameter for one set of data, say in the past, that you're analyzing some stocks or a portfolio, that may not predict future results, if you will. and the more detailed and the more variables that you apply to that prior data set to get that optimization, the more unlikely it is that it's going to perform well in the future. So what you are trying to do is find the fewest parameters to change for your past data because that will give you a lower variance in terms of trying to guess at the future at what a portfolio might do in the future. That goes to what we call the simplicity principle, which is that the more simple system you have set up, the more likely it is to continue to perform the same way. The more variables and oddball things that you apply to it to make the past data perform better, the more likely it is to have a high variance in the future and not actually perform the same. So you get back to, well, what are some decent rules of thumb to use? And so what we have applied to the risk parity style portfolios is for the four basic ones, we are using just an annual calendar rebalancing simply because that is the baseline that most people would use. It's good for tax purposes and it causes you not to fiddle around too much with the portfolio during the year or be tempted to do strange things with it. Now for the other two, the experimental portfolios, we went with tolerance bands and we decided to use 7.5% absolute as the trigger for rebalancing. We also tie that with a calendar notice because obviously you could be looking at these things every single day or every single hour to see whether they triggered a band. It's much easier than to look at them on an established schedule. And for us, we are looking at them mid-month. So we every mid-month we look and see Whether those two portfolios, whether the components in them have triggered a band by going outside of the original allocation by more than 7.5%. And that's the way we're handling those. Whether that's optimal or not is a good question. On basic backtests, it seemed to be fairly optimal, but whether it's going to be optimal in the future, is not entirely that clear. Now, of course, the advantage of rebalancing is that it is forcing you to sell high and buy low, and that's why you want to have a rebalancing strategy so that after something has performed really well, you're selling it at a high point or selling some of it and buying some of the components in your portfolio that have not been performing well. are likely to perform well in the future simply because there is a reversion to mean and these things just tend to go up and down over time. Now looking at the aggressive 5050, the portfolio that we are rebalancing and what we see there, you see this on the portfolios page, you see that the investment in UPRO has gone from 33% of the portfolio to now being 40.56% of the portfolio. So it just triggered the 7.5% rebalancing band for rebalancing. And it did it mid-month. We're here at November 15th. And so we're going to rebalance it. So what does that mean in practice? It means that we will be selling a bunch of UPRO and buying the other components that are on the low side. Here those components are the TMF, the Treasury Bond Fund, which is negatively correlated with the stock fund. So as you can imagine, has gone down considerably when you compare it to the stocks. And it is right now it started at 33% of the portfolio and now is down to 26.41% of the portfolio. In addition, the Vanguard Intermediate Treasury Bond Fund, which is ordinarily at 17% of this portfolio, has gone down a little bit to 16%, so we'll be adding a little bit to that. And since we know we'll be taking some money out of this at the end of the month, we're just going to leave some of it in cash so we don't have to go back and resell something again in two weeks. And so what this ends up being is our rebalancing, which will happen on Monday. We will be selling $794 worth of UPRO and we will be buying $694 worth of TMF and $63 worth of VGIT. That will rebalance our portfolio back to its original allocations of 33, 33, 17, and 17. We don't need to add anything to the PFF, the other component here, because it is pretty close to where it started. That will leave us $37 in cash, which will be added to the $38 in cash that's already sitting there from dividends and will be used to make the distribution for December. So it'll be interesting to see how this now performs in the future, especially since we have another portfolio with similar components in it. The accelerated a permanent portfolio that we are not rebalancing at this point in time. In theory, this kind of action should make this portfolio perform better over time simply because it's giving us that opportunity to sell high and buy low. Just one final note on the concept of rebalancing. One of the problems that you have in taking these analyses of rebalancing from the academic studies is that they are generally looking at static portfolios then. In reality, nobody has a really a static portfolio. You're either putting money into a portfolio and accumulating in it, or you're taking money out of it when you're drawing down or decumulating from it in retirement. So what that ends up getting you to is there is an automatic rebalancing that tends to go on all the time. As you put more money into a portfolio, typically what you would do is buy the thing that is low in terms of percentages or allocation to shore it up. And then you wouldn't have to rebalance as much anyway. On the flip side of that, and what we're doing in our portfolios, is we are selling things that are high to begin with. And so that in effect does a little bit of the rebalancing as you go, as you take the distributions every month. Now I'm not aware of any studies that really monitor that or reflect that and how that affects rebalancing, and you can see that it's going to be different in every case, so it's very difficult to analyze that sort of thing. Which goes back to why you can use rules of thumb for this because trying to optimize it too closely will give you a false sense of security that what you're doing is really optimal for the future. All you can say is what you're doing is optimal for the past and so you need to make it simple so it's more likely to continue on into the future, the more complicated it is the more torture you apply to past data, the more likely that what you are doing is not going to perform the same way in the future. But now I see our signal is beginning to fade. If you have comments or questions, please send them to me at frank@riskparityradio.com that's frank@riskparityradio.com or you can go to the website and fill out the contact form. That's www.riskparadioradio.com. This podcast crossed the 2500 download threshold last week and I want to thank all of our listeners for that. At the beginning, I was hoping to have 10 loyal listeners. It appears I have at least 40 now and the number seems to be growing every week, so it's very gratifying that people are finding this presentation of value. So thank you again. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [23:40]

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.