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 37 of Risk Parity Radio. Today on Risk Parity Radio, we are going to have a little bit of a back to basics episode to discuss the basics of portfolio construction, the three principles that we follow, and some interesting observations as to how we see those things evolving in the personal finance space. And then we're going to have a rant, because it's the beginning of the month and it's time for the monthly rant. But before that, I wanted to give a shout out and thank you to Diana Miriam. She is the podcaster of Optimal Finance Daily, which is one of the top 10 personal finance podcasts according to Investopedia. Anyway, she mentioned us and our podcast in her episode on Monday. That's episode 1361 of Optimal Finance Daily. If you want to go look that up. and we'll actually be talking a little bit more about that episode today. But now let's go to our three principles. Now we discussed these three principles in some detail in episode seven, and so you might want to go back to that. These are our three basic principles of portfolio construction, and those three principles are First, the Holy Grail principle, and second, the macro allocation principle, and third, the simplicity principle. And we'll review each one of these and what they mean briefly and then talk about a recent application I have seen of each one of them or something close to it. Now first the Holy Grail principle. The Holy Grail principle is from Ray Dalio and he calls it the Holy Grail of investing. And what it is is a statement or recognition that in order to construct a portfolio that maintains high returns but lowers the risk, you have to construct it out of uncorrelated assets or better yet, negatively correlated asset classes. And the more assets you put into it that have low correlations, the lower the risk will be for the same level of return. Now you see applications of this or examples of this in funny places People don't often yet still say I'm doing risk parity style investing even though they may be doing it without recognizing it as such. And where did I hear this recently? It was on a Bigger Pockets Money Podcast episode 153. And this was an interesting podcast because it was an interview of Bill Bengen who is the progenitor of the 4% rule. Now I won't go through everything he had to say on there, but you should listen to it. Basically that is something he came up with in the 1990s. He thinks today it may be even a little bit too conservative, particularly in low interest rate environments. because the 4% rule, the original one, did build into it inflation. And since we are in a low inflation environment, he thinks it may be a little bit too conservative at the moment because of that. But you'll have to go listen to it for his analysis. He's also published several articles about this recently. But where did the Holy Grail principle come into this. Where it came in was an interesting part towards the end of the podcast where they were simply asking him what he was invested in. And you might think that the author of the principle would be invested in something like a 60/40 portfolio or a 50/50 or a 75 standard kind of stock bond sort of thing. Because that is what the original 4% rule was applied to is that kind of portfolio. So they asked him and what did he say? He said currently he was invested 25% in stocks, 5% in gold, and the rest in fixed income including a tranche of CDs that he had bought back when interest rates were a little higher back up at 3%. Now, what does that sound like? What is it? Have we heard about portfolios like that before? It looks, it sounds a lot like what we have on the website as the all-weather portfolio. It's a very conservative risk parity style portfolio is what it is. That 5% gold in it really clues you into what's going on here, that he's got three uncorrelated asset classes in a conservative mix. Now he didn't mention risk parity and he didn't mention the Holy Grail, but as soon as I heard that my ears perked up because it's always interesting to listen to people who have the most experience in investing what they actually invest in for themselves. Now he is an older gentleman, so he needs a more conservative or would want a more conservative portfolio. So I could understand why his stock percentage is as low as it is for him. But I was surprised to hear about the gold and the large portion of fixed income that he's got. So let's move on to our second principle, which is the macro allocation principle. Now where does this come from? The easiest place to reference it, I think, is in chapters 18 and 19 of Jack Bogle's Common Sense Investing. And what he says there, based on a number of studies going back to the 1980s, is that the performance of a portfolio in comparison with other portfolios is largely dictated by its macro asset allocations, those stock bond other proportions to it, and not by what is within each part of the allocation, assuming those allocations are reasonably well diversified. Basically, what he says in the book is that 94% of a portfolio's performance is going to be dictated by that macro asset allocation. Others have said 90% that's the figure I use 90% plus. You know what that means in practice is that your 60/40 portfolio, it's going to get diversified in a few funds within each section of it, and it's not concentrated on just a few stocks, is going to have 90 5% plus the same kind of performance that any other 60/40 portfolio or any 80/20 or if you have more asset classes suppose it's 40/30 10 and 10. That doesn't add to 100, does it? Suppose it's 40/30 20 and 10. And you have another one that's also 40/30 and 20 and 10 in the same kinds of asset classes. Basically this principle says that it's setting up those macro allocations that really matters and what you should focus on and not be focused or fixated on the funds within each macro allocation. Now what is the application of this recently? Well there is a corollary to this that is that it does not make sense to go chasing after the hot fund or the hot sector, I should say, the hot allocation, because what you would be doing then is screwing up your plan and you'll end up likely underperforming the markets over time or underperforming the allocation that you have over time. because you're not sticking with it and you'll end up buying high and selling low if you chase. Where did I hear something like that? It was actually in that Optimal Finance Daily episode 1361 that we were mentioned in. And it was a small look at a at asset classes over a period that was 1998 or 1999 to 2018. And it found that REITs were the best performer over that period. Well, that's all fine and good, but if you were to have followed that, REITs were a terrible performer recently over the past couple of years. It was a stark reminder that what you need to do is set your macro asset allocation and then not chase based on some segment of data, the most recent segment of data, or some smaller segment of data that might suggest this one is going to be better. So I need to put more into that one now and change what I'm doing. you're better off sticking with your macro asset allocation and rebalancing and riding it out. Now what is the third principle that we're going to talk about? It's the simplicity principle. Now the simplicity principle says don't use more funds or more complicated assets or structures than you have to because more complicated things are harder to manage and therefore likely to underperform if you can do it with a simpler version of the same thing. Now where did I hear an application of this most recently? It came on the Earn and Invest podcast from November 30th, which featured Paul Merriman and Richard Buck who have a new book out called 12 Steps to Supercharge youe Retirement. And they were talking about a shift that Merriman had made that he had previously recommended a more complex portfolio that was composed of about 10 funds. They have now moved to something called Two Funds for Life. Now, why did they do that? It wasn't that the more complicated portfolio was bad or had a problem with it. In fact, it's a very good portfolio. But Merriman had an interview with John Bogle a few years before he died, and a light bulb came on. A light bulb came on because what Bogle told him is that your portfolio is great, but it's just too complicated for most people. You should have something a little simpler that somebody is going to be daunted by and that's easier for somebody to manage. They'll make less mistakes. And Paul Merriman took that advice to heart and went and worked on this with his colleagues and came up with this two funds for life portfolio, which happens to be a target date fund and a small cap value fund. that varies over time based on age and some other factors. But what I thought was interesting about that is it just was an application of this simplicity principle that is essentially accomplishing the same goal with something simpler. You ought to do it that way. And for us, that means in our stock portions, for instance, our portfolio, We don't need to have 15 funds or 50 stocks or something like that. We can just have three or four funds for a particular asset class, or just one may be sufficient in most cases. And it references back to that macro allocation principle that it's better to focus on the macro asset allocations and not the funds within each allocation. Focusing on low fees and low expenses is really what you want to do with respect to those and just make sure they are diversified in a way that you think is appropriate. And now what you've all been waiting for. Well, at least I know a couple of you have been waiting for it. It is time for our Monthly Rant About Financial Miswisdom. We better cue the music here. All right, we're ready to rant. This month's rant is about the annual predictions racket, which comes around each time of year. around December, usually between the two holidays. And what this is is everybody in their uncle is asked or puts out a prediction for what the markets are going to do next year. And I'm just reminded that these opinions are like certain orifices on our bodies. We all have them, but that doesn't mean we need to be talking about them. What do you see in these predictions? Well, if you look through a series of them, typically the same people will predict the same kinds of things almost every year. So the large law, Wall Street firms, they will predict that we're going to have average returns, or if this year was bad, maybe they'll be a below average. If this year was good, maybe the next one will be above average. You see things like, well, there's higher volatility now, so we'll say there's higher volatility next year. And there's likely to be a rotation. There's always got likely to be a rotation. And what they'll say is, well, the things that are doing really well right now may not do as well next year. and some other things may do better. And then the other famous buzzwords are, I think this has become more going to become more of a stock pickers market, a stock pickers market. Why is it supposed to be a stock pickers market? It's that seems to be a perennial desire or wish. And in fact, I believe it is a wish because these Wall Street firms tout themselves as great stock pickers, so they want to have a stock pickers market so that you can come in the door and pay them to pick stocks for you. So it's not about actually predicting, it's about marketing. And what other kinds of predictors or predictions do we see out there? Well, you have a series of Perma Bears that love to predict market crashes. This year's Perma Bear that I pulled off YouTube and just go put in Stock Market Crash 2021 into your search engine or the YouTube engine. You'll find all kinds of these things. But anyway, Harry Dent says that we're gonna have a 40% decline in the stock market for sure. by April. He said these things before and there are others who say that every year there's going to be a stock market crash. What are those people usually selling? Those people are usually selling some kind of newsletter, book, or basically themselves to get themselves on more media and hopefully get more speaking engagements. And some of them have some funds that they run or they advise, and so they want people to get involved in that. And so they are most likely to give you more dramatic predictions. What's interesting about these sets of gurus is they almost never say what the Wall Street firms say, which is it's gonna have an average return or slightly above or slightly below. Instead, they're always saying, It's going to double or it's going to half or something is going to explode. And of course, they'll tie it to whatever is in the news at the time. The elections, vaccines, whatever it is. If there's nothing else to talk about, they'll start talking about the national debt or trade imbalances or something to back up a narrative. But it's, again, it's, it's not a real prediction that's based on anything. It's marketing is what it is. And then you see the more specialized predictors. You have gold bugs that are saying gold is going to shoot to the moon. And the one I saw most recently was gold is going to hit new highs by February. Is gold going to hit new highs by February? I have No idea. All I know is these predictions are completely worthless. They are for entertainment purposes only is how I would characterize them. And then there are the interest rate predictors. There are always people predicting that interest rates have to go up. And usually the justification is, well, they've been going down, so they have to go up now. They've been going down, so they have to go up now. No, they don't. They don't have to do anything. But there are another series of interest rate predictors that are always predicting this is the year that interest rates go to zero. This is the year that interest rates go to negative. Always something dramatic. In my experience, none of these people are terribly accurate. and in any given year interest rates may go up, they may go down, they may do some of both, and they often do fluctuate over months of time, if not years. And again, you need to take these things for entertainment purposes only. I see a lot of people that get agitated on various boards and they say, I hear the stock market's going to crash. What am I going to do? What am I going to do? the problem most of them have is that they don't have a plan to begin with. You need to go back and if you don't have a plan, make a plan and then stick with your plan and stop looking at YouTube or financial TV or wherever these things are coming from. And they come in droves at this time of year and just Forget about it. Leave it alone. Work your plan, stick with your plan. And this is where we get to back to what you should be doing as far as a risk parity plan is following those three principles that we talked about. Following that Holy Grail principle, the macro allocation principle, and the simplicity principle. If you do those things, you're probably going to come up with a pretty good portfolio that will serve you well. We will be looking at some more of those portfolios I talked about in future episodes. I thought we would take a look at the Paul Merriman's Two Funds for Life portfolio, at least as how it would appear for somebody at retirement age and see what that looks like if you tweaked it a little bit on risk parity style principles to see how it would perform as is and with a little more diversification, if you will. But we're gonna save that for another episode, not the next one or maybe the next one. maybe later this month to make it exciting. But now I see our signal is beginning to fade, so it's time for me to say goodbye. I've been getting some nice comments, interesting comments in the emails that will help me construct new episodes as we go forward. If you'd like to contact me, you can send an email to frank@riskparityradio.com That's frank@riskparityradio.com or you can fill out the little form at the website. The website is www.riskparityradio.com and there is a contact form there on the page down below at the bottom. We will be continuing next time this weekend with our weekly portfolio review and discussing the distributions from the sample portfolios for the month of December. Again, you can find those portfolios at the portfolios page at www.riskparadioradio.com. If you haven't done it already, I would appreciate it if you would leave me a little review on Apple Podcast or wherever you listen to this podcast because those are helpful in spreading the word, if you will. Thank you for tuning in. This is Frank Vasquez with Risk Parity Radio, signing off.

Mostly Mary [24:11]

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.