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. Thank you, Mary, and welcome to episode 42 of Risk Parity Radio.

Mostly Uncle Frank [0:42]

Today on Risk Parity Radio, we are going to play around with a couple of Paul Merriman portfolios, and we are also going to take a look at a portfolio designed by one of our listeners, Brad. Now for those of you who do not know who Paul Merriman is, he is a former financial advisor who has devoted the past couple of decades of his life to financial education and he has put forth a lot of good material for do-it-yourself investors including a portfolio called the Merriman Ultimate Portfolio and most recently a portfolio called Two Funds for Life. And now he has been doing the rounds with his new book that he wrote with Rich Buck and that book is called We're Talking Millions：12 Ways to Supercharge youe Retirement. And I will link to one of the podcasts, the Earn and Invest one where he recently was on there and explained how these portfolios and how these things have evolved recently. And what he says in sum is that taking his Merriman Ultimate Portfolio, and while it was a good portfolio, he went to see Jack Bogle and Jack Bogle gave him an interview and they sat down. And one of the things that Jack Bogle said to Paul Merriman during that interview or discussion was that the portfolio was excellent, but it was probably too complex for most people to manage. And so thinking about that, Paul went and came up with an alternative that would be easier for somebody to manage, which is called the two funds for life portfolio. Now that portfolio is designed with a target date fund and a small cap value fund as its basic two funds. And the idea of is you start with a large portion of the small cap value and both the target date fund. But as you age, you phase out the small cap value fund until you're left with just the target date fund at retirement. And it gives a high balance of stocks to begin with, and then by the time you get to retirement age, you are looking at kind of a standard portfolio for retirement. And so I thought what might be interesting is to look at that portfolio in retirement that you would end up with at age 65 and see if we could tweak it a little bit with some risk parity ideas. to see how it would perform if we made it a little bit more diverse in accordance with our Holy Grail principle. And so I went ahead and did that. I did it over at Portfolio Visualizer and we had data there for this comparison that goes from January 2001 to November 2020. And just so you can understand what is in these two portfolios, the resulting two funds for life portfolio at age 65, what that looks like is essentially a target date retirement fund, like a Vanguard target date retirement fund. And what is in that for somebody who's retiring is 30% in the US stock market, 20% in global stocks that are outside the US or international stocks, and it's got 30% in a total bond market fund, and it's got 10% in global bonds or international bonds, and then it's got 10% in TIPS, those Treasury Inflation Protected Securities. And so it's basically a 50/50 portfolio, which is a nice standard kind of portfolio you would find in retirement. Now, I thought that we would want to tweak this a little bit, and the way I wanted to tweak it to make it more risk parity style was really to leave the stocks alone. So we just left those two components alone in our tweaked portfolio, our risk parity alternative. It is still 30% US stock market and 20% international stock market. But then we took the bond component and changed that up a little bit. What we wanted to do to make it more of a risk parity style portfolio is to get rid of the corporate bonds that are in it. The reason we want to get rid of the corporate bonds and just have treasuries is that we don't want bonds that are correlated with the stocks. We want bonds that are negatively correlated with our stock component. And so we took those bonds and changed that bond component into 30% long-term treasuries and 5% in cash. The reason we have 5% in cash is to have something to withdraw from and also because it gives kind of a barbell style bond allocation that basically you have bonds that are long duration and then the cash is essentially bonds of zero to one year duration. or the equivalent thereof. And then in order to tweak it just a little more, we took the tips and some of the other bond component and changed that into a gold component. So we made it 15% gold. So this portfolio, this risk parity alternative or tweaked portfolio looks like 30% US stock market, 20% international, 30% long-term US treasuries, 15% gold and 5% in cash. And so then we ran this analysis for the past 20 years comparing these two portfolios. And looking at the two funds for life portfolio for this time period, it had a compounded annual growth rate of 6.31% with a best year of 21% and a worst year of -19%. the risk parity alternative had a higher compounded annual growth rate of 7.77%, so that's about 1. 5% better. It also had a similar standard deviation, 8.19 to 8.29, but really where it had the biggest difference is that its best year was almost exactly the same as the two funds for life, but the worst year was only down 12.36% as opposed to 18.97%. What that ends up getting you is a better risk reward ratio, which is measured by the Sharpe ratio and the Sortino ratio. In the Sharpe ratio comparison, the original two funds for life at 65 is a Sharpe ratio of 0.62. and the alternative is 0.78. And then the Sortino ratios are 0.91 for the two funds and the risk parity alternative is 1.21, which is also significantly better. And if you look at their trailing returns, the risk parity alternative was in fact better for just about every trailing return period except for the last three months. but it was better year to date, better one year, better three, five, eight, and the full 20-year period. And then just looking at a couple more metrics here for this comparison, the calculated safe withdrawal rate for the original portfolio is 7.1 and that compares with the risk parity alternative is 7.93%. And then if you look at the perpetual withdrawal rates, you get 4.2 for the original two funds and 5.56 for the perpetual withdrawal rate for the Risk Parity Alternative. So again, you can see the improvement there and you can see, and you will find this to be true in most cases, if you take any given portfolio and then if you go and tweak it a little bit, To make the alternative components to stocks less correlated or negatively correlated with your stock component, you are going to see better performance in these kind of metrics because it'll have a lower or less of a drawdown, and so it'll have a better safe withdrawal rate on the other side of it. Now we also wanted to do another comparison of a portfolio that looks more like the Merriman Ultimate. And so we went and got that data off from the Merriman site. He's got a lot of links there, including to some Google Sheets with all of the data necessary to construct one of these portfolios. And this is essentially a Merriman Ultimate Glide Path at age 65 as to what it would look like. And this is a very complicated portfolio, and I will read you the funds. It's got 7.88 in Vanguard Small Cap Value, it's got 7.87 in Vanguard S&P, well, it's a second small cap value fund. One of them is VBR and VIOO. Then it's got 7.88 in VONV, which is a Russell 1000 fund, 7. 88 in Vanguard S&P, that's VOO. And then we go to international funds. It's got a small cap international, component DLS, that's 2.7% of this portfolio. It's got a Vanguard FTSE All World, another small cap ETF called VSS, 2.7% is in that. EFV, that's iShares MSCI EAFE Value Fund, another international value fund, 2.7% in that. VEA, that's Developed Markets Fund, 2.7% in that. VNQ, that's US real estate, and we got 3.5% in that. VNQI, which is global real estate, and so there's 1.5% in that. And then we get to the bonds. There's 15% in short-term treasuries represented by VGSH, 25% in intermediate-term treasuries represented by VGIT in this, 10% in TIPS, that's represented by Vtip, that's a short-term TIP fund. And then we also have a couple of emerging markets ETFs, 1.35% in VWO and 1.35% in EWX. And that is a mouthful, but it is all there on the link that we will provide to this analysis. What it ends up being is a 50/50 style portfolio that is actually similar to the less complicated one that we described in the first analysis. And we're comparing this to the same risk parity alternative portfolio that we used in the other analysis. So that's got 30% in US stocks, 20% in international stocks, 30% in long-term treasuries, 15% in gold, and 5% in cash. Now due to all of the components in here, the analysis only runs from 2012, November 2012, until November 2020. But taking a look at the results of that analysis, this Merriman Ultimate Portfolio had a compounded annual growth rate in that period of 6.14% compared to the Risk Parity Alternative, which was at 7.86%. The standard deviation was lower for the Merriam Ultimate at 6.85 compared to 7.4 for the Risk Parity Alternative. The worst years were similar, negative 4.6 for the Merriam Ultimate, negative 5.13 for the Risk Parity Alternative. But the max drawdown for the Merriam Ultimate was greater. It was negative 11.86% compared to -7.23% for the alternative. So that ends you up with sharp ratios of 0.80 for the Merriman Ultimate and 0.96 for the Risk Parity Alternative. So again, you see an improvement there in the risk reward ratio and similarly the Sortino ratio for Merriman Ultimate was 1. 2 and for the Risk Parity Alternative is 1.67. So that is also an improvement there. US Market Correlations, I should note that as well. The Merriman Ultimate has a, it follows the market pretty closely at 0.95. The Risk Parity Alternative is a bit different and its correlation with the total market is only 0.72. and this translates on trailing returns to show that the Merriman Ultimate here for the last three months outperformed the Risk Parity Alternative, but if you look at year-to-date, one year, three year, five year, or the full period, the Risk Parity Alternative does better in each one of those periods. And that ends up translating into a projected safe withdrawal rate and take these with a grain of salt because of the period was abbreviated and was a very good period for the stock market. It is 15. 18 for the Merriman Ultimate and actually a slightly less for risk period alternative at 14.6. But then if you look at the perpetual withdrawal rate that's reversed 4.44 for the Merriman Ultimate and 5.98 for the Risk Parity Alternative in that case. So again, what we see from this is that by taking a look at your assets, the particular ones that are alternatives to stocks, looking at your bonds and putting a little gold in there, as we've learned from our other analyses, having 10 to 15% gold seems to be a sweet spot for these sorts of portfolios. But doing those things tends to improve the performance of just about any stock bond portfolio that you can come up with. And what's also notable here is what Jack Bogle told Paul Merriman is that the much more complicated portfolio really was no different in terms of performance than the two fund portfolio, the earlier one that we looked at, that was just diversified with a couple of funds instead of 15 different funds. And that is an example of what we call the simplicity principle, so one of our three principles, that we want to take the simplest formulation we can get at to arrive at our portfolio selections because it's going going to be easier for us to manage. And now let's turn to our third analysis of the day. One of our listeners, Brad writes in and message to me saying that he had constructed an alternative to the Golden Butterfly portfolio that he thought was better and that he liked and he wanted to know what I thought of it and it is a pretty good looking portfolio. I did another analysis with it and against the golden butterfly just so we can see what these things are. Now what he's got in his portfolio are 20% in gold, 20% in long-term treasuries represented by TLT, 20% in intermediate treasuries and he's using IEF for that. And then his stocks are a little bit different from the Golden Butterfly, they are focused or concentrated in a couple areas. So he's using XLY, which is a Consumer Discretionary Sector Fund, and VGT, which is in Vanguard Information Technology Fund. There's 20% each of those. Now that compares to the original Golden Butterfly, which is one of our sample portfolios on the website, www.riskparityradio.com. And what is in that is 20% total stock market, 20% small cap value, 20% in gold, 20% in long-term treasuries, and 20% in short-term treasuries. And so we did that comparison on Folio Visualizer site. We had data for this portfolio going back to December 2004. So we have December 2004 to November 2020. And looking at that, you can see that Brad's alternative is a much better performer over this particular time period. The Golden Butterfly is a compounded annual growth rate of 7.9% and Brad's alternative is at 10.46%. The standard deviation for the original Golden Butterfly is lower, 7.53, but the other metrics are similar. Best years of 18 for the original and 23% for Brad's. Worst years, minus 4 for the original, minus 3.8 for Brad's. Maximum drawdowns of 14.8 versus 14.9. And then we have the sharp ratios, and the Golden Butterfly sharp ratio for this period was 0.88. with Brad's, which is 1.12. So you can see that Brad's portfolio does better in this time period for what it is. Now that leads us to the question of why. And in order to analyze that, you really need to look under the hood, particularly when talking about stock funds, because if you're taking a concentration, you want to know what exactly is in that. And if you look at these two funds that he's picked, XLY is 20% Amazon and 11% Home Depot. And those have been two of the best performing stocks over this period. The Vanguard Information Technology Fund is even more concentrated. It is 35% in two stocks, Microsoft and Apple. And of course, those were two of the best performing stocks. over this time period. What does this mean? Well, this is where we get to a statistical phenomenon known as the bias variance dilemma. I'll try to explain that briefly, and it is related to a phenomenon known as overfitting of data. That if you pick specific variables for a particular set of data, and they are sort of the best you can get for that set of data, the chances are of having a greater variance or not the same kind of performance in another set of data end up getting pretty high because basically what you're doing is picking the best thing for a particular period. So this comes down to how would this portfolio have performed in other periods of time? And the answer is we can't say for sure, but we do know it would probably have been different. First of all, these stocks did not exist in many other time periods. But if you go back to the 1970s, there were a group of stocks that were the high technology flyers of that time. They were Companies like Polaroid and Xerox, and they were part of a group of stocks that was known as the Nifty Fifty. And the idea of this Nifty Fifty, which was come up with in the 1960s, were that these would never go down. That these 50 stocks were so good and the companies were so good that you could always invest in them with confidence. Unfortunately, that did not work out as these things usually come to an end at some point. Any group of stocks has its heyday and then has its problems. And it had a lot of problems in the 1970s. As the decade wore on, those stocks underperformed the rest of the stock market by large margins. Now, whether that's going to happen to today's high-flying technology stocks, I can't say or when it's going to happen, but it is a possibility that needs to be taken into account. And it is actually interesting, it's for this reason that the Golden Butterfly has that component of small cap value in it, because the stocks that tend to do well in environments like the 1970s, which are inflationary, are small cap value stocks. why that is, I don't know. Man's got to know his limitations. Somebody else does know, but there are a lot of articles that I've read that suggest that in an inflationary environment, small cap value is the way to go, and in deflationary environments like the ones we've had, large cap growth is the way to go. All of this ends up getting us to lots of complications with no answers. So where you end up coming out here is the safer course for these kind of portfolios is always to take the broader class because the chances of a broad class of stocks, like a total stock market, performing the same or similarly in different time periods is much higher than the chance of a concentrated or focused portfolio of stocks of performing the same way in two different time periods. Now this does not mean that Brad should not keep his portfolio if he's comfortable with the technology stocks and many people are, then that is a good way to improve your returns on this. You just need to be cognizant that there is some additional risk involved in focusing a portfolio on a particular sector or particular stocks. Just one other thing from Brad's note, and I do thank him for writing in. He mentioned that he was planning on using IAU as his gold fund, which has an expense ratio of 0.25%. That is better than the expense ratio of GLD, which we use for our analyses because it goes back farther. But the best alternatives in that space now are the two funds, GLDM with an expense ratio of 0.18 and BAR, BAR with an expense ratio of 0.17. Both of those are relatively new gold funds, so there's not a lot of data on them, but they have the same things in them as the other funds that cost more. So those are the best two alternatives as of this year. Who knows, there could be an even cheaper gold fund from Vanguard coming out next year, but I'll let you know if that happens. But I see now that our signal is beginning to fade, and so it is time for me to say goodbye. We will be picking up again with our weekly portfolio reviews this weekend. and that'll be our next show. There will be a lot of links in the show notes because we talked about a lot of different things, some of the Merriman stuff, I'll link to, it's very interesting. And if you are a committed DIY investor, it's really something that you want to have looked at because he's got so many good ideas. If you'd like to contact me and a couple of other people have contacted me about we will be constructing new shows based on some things that people have sent me, but you can send your email to frank@riskparityradio.com that's frank@riskparityradio.com or you can go to the website www.riskparityradio.com and fill out the contact form there and I'll get your message that way.

Mostly Mary [26:27]

Thank you for tuning in and Merry Christmas This is Frank Vasquez with Risk Parity Radio signing off. 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.