Voices [0:00]

A foolish consistency is the hub goblin of little mind, 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 Queen 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 have just stumbled in here, you will find that this podcast is kind of like a dive bar of personal finance and do-it-yourself investing.

Voices [0:52]

Expect the unexpected.

Mostly Uncle Frank [0:55]

It's a relatively small place. It's just me and Mary in here. And we only have a few mismatched bar stools and some easy chairs. We have no sponsors, we have no guests, and we have no expansion plans.

Voices [1:10]

I don't think I'd like another job.

Mostly Uncle Frank [1:13]

What we do have is a little free library of updated and unconflicted information for do-it-yourself investors.

Voices [1:23]

Now, who's up for a trip to the library tomorrow?

Mostly Uncle Frank [1:27]

So please enjoy our mostly cold beer served in cans and our coffee served in old chipped and cracked mugs. Along with what our little free library has to offer. Which is attend to your email. Did you get that memo?

Voices [2:03]

Yeah, I got the memo.

Mostly Uncle Frank [2:04]

And so without further ado.

Voices [2:06]

Here I go once again with the email.

Mostly Uncle Frank [2:09]

And first off. First off, we have an email from Roman.

Voices [2:24]

All hail Caesar, Emperor of Rome, monarch of the Roman Empire, ruler of the world.

Mostly Uncle Frank [2:32]

And Roman rights?

Mostly Queen Mary [2:34]

Please move this question to the front of the line as I recently donated to the Father McKenna Center.

Voices [2:40]

Groovy baby!

Mostly Queen Mary [2:42]

I recall hearing that there is no free lunch in investing, with the possible exception of diversification, but it seems to me that leverage, when properly applied to a diversified portfolio, is a strong contender as well. I have noted that your leveraged sample portfolio, such as the levered golden ratio or OPTRA, both support perpetual withdrawal rates exceeding 5% long-term baseline for the standard golden ratio portfolio. This makes sense to me, since if you take a non-leveraged portfolio that would otherwise support a 5% withdrawal rate and lever it above 100% while still maintaining its overall diversification, then you could theoretically proportionately increase the withdrawal rate consistent with the amount of leverage. For example, if 5% can be safely withdrawn from an unleveraged portfolio with 100% exposure, 100% divided by 20 equals 5%, then a portfolio with 120% exposure should support a 6% withdrawal rate. 120 times 5% equals 6%. A portfolio with 140% exposure should support a 7% withdrawal rate. 140% times 5% equals 7%, and so on. I'm sure this phenomenon does not go on forever, but assuming a reasonable amount of overall leverage in a portfolio and maintaining the appropriate ratios of uncorrelated or weekly correlated asset classes, is this the right way to think about the effect of leverage on the withdrawal rate that a portfolio can potentially support? Or am I overlooking some critical pitfalls with this approach? If so, I am very interested in hearing what these might be. Thank you for your show. And I am one of those who was initially put off by all the sound bites but eventually came to enjoy them, Roman.

Mostly Uncle Frank [4:32]

Well, I'm glad you're enjoying the sound bites. After a fashion, as it were.

Voices [4:42]

Did you kill last week? No. Did you try to kill last week? Yeah. Now listen, this is your last week of unemployment insurance. Either you kill somebody next week or we're gonna have to change your status. You got it? Yeah. Sign.

Mostly Uncle Frank [5:02]

But I'm even more glad that you're a donor to the Father McKenna Center. As most of you know, we do not have any sponsors on this podcast. We do have a charity we support. It's called the Father McKenna Center, and it supports hungry and homeless people in Washington, D.C. Full disclosure, I'm on the board of the charity and am the current treasurer. But if you give to the charity, you get to go to the front of this email line, which is about three months long. So if you'd like to do that, there are two ways to give to the charity. First, you can go to the donation page of the Father McKenna website, which I'll link to again in the show notes. And second, you can go to the support page at www.riskprediary.com and become one of our patrons on Patreon. Either way, you get to go to the front of the line, but please do mention it in your email, as Roman has done here, so that I can duly move you to the front of the line.

Voices [5:56]

Yes!

Mostly Uncle Frank [5:57]

But now let's get to that email. Leverage is an interesting topic that we have pondered here, and I continue to ponder, since I really do not know what the ultimate answers are as to the optimal leverage in a drawdown portfolio. And that's kind of the $64,000 question. What's the answer? What's the answer? So here are some just considerations about this in general. There's a nice Ben Felix video that I'll link to in the show notes where he cites some academic studies showing basically if you want to outperform markets, there are two ways to do it. You can either take a concentration in something that you think is going to outperform the market, or you can take leverage. Now, of course, the main problem with taking leverage is a lot of people who take leverage blow up and lose all their money. And that's not good.

Voices [6:48]

You have a gambling problem.

Mostly Uncle Frank [6:50]

And that happens to even the finest investors available famously to long-term capital management back in the late 1990s, which was a whole bunch of Nobel Prize winners and other very sophisticated investors who put too much leverage in some bets on Russian currencies and Russian debt, and it really blew up in their face.

Voices [7:12]

We can put that check in a money market mutual fund, then we'll reinvest the earnings into foreign currency accounts with compounding interest, and it's gone.

Mostly Uncle Frank [7:21]

And that's happened to many others over many years.

Voices [7:25]

Uh what? It's gone. It's all gone. What's all gone? The money in your account. It didn't do too well, it's gone.

Mostly Uncle Frank [7:32]

On the other hand, taking leverage has been one of the cornerstones of how hedge funds traditionally used risk parity style portfolios. Because what they would do is take a very conservative portfolio like that all-season sample portfolio, something that looked like that, that had a whole lot of bonds in it, and then add leverage to that to make it have the same risk profile as, say, the stock market, with the idea that it's going to have that same risk profile, but a lower volatility overall, and so have essentially a higher sharp ratio or be more efficient in terms of risk versus reward. And people who start with a very conservative portfolio and add leverage to that typically do not blow up if they're reasonably careful about it. But one of the key drawbacks to leverage, particularly in a drawdown portfolio, is what is called volatility drag. And the easiest way to illustrate that is if you had a portfolio that lost 10% of its value in a year, in order to make that back the next year, it would have to make 11% back. And that's not a very big difference. But if that same portfolio loses 20% in a year, then in order to make that back, it has to get up 25%. And the more it loses, the more volatile a portfolio is, the more it has this drag on getting back to even. And we've seen this in the sample portfolios, which is one of the reasons I wanted to construct them to see how this would all work out. So if you look at the most leveraged and the least diversified of those sample portfolios, which is the aggressive 50-50, that was modeled after something that it's called hedge fundy's excellent adventure, which was popular about five years ago, and you can look up, which is basically a portfolio of completely leveraged funds divided into a fund like you pro, three times leveraged S P 500 with it with a fund like TMF, which is three times leveraged Treasury bonds. And that portfolio has been the worst performer out of the sample portfolios, primarily because of this volatility drag. That initially, when everything was going up, it performed the best and it reached the highest peak at that time. But then when we had that crash in 2022, it essentially lost half its value and has struggled since then, largely due to the volatility drag. But the one thing that adds to that is if you are taking money out of a portfolio doing withdrawals, it increases the overall volatility of the portfolio and so drags it down even more, essentially. And since we were subjecting that thing to an 8% withdrawal rate originally and have been subjecting it to 6% since it went under its starting value, that has also contributed to its underperformance. So it's been an ugly experiment on paper, but it's been a very educational experiment in how leverage and volatility actually work.

Voices [10:27]

Well, you have a gambling problem.

Mostly Uncle Frank [10:31]

Now there's an important paper that we've cited about this back in episode 440, and it's written by a guy named Jim Sandage, and it is applying chaos theory essentially to draw down portfolios and observing this phenomenon that when you start taking money out of a portfolio, it naturally adds to the volatility or chaos of the portfolio.

Voices [10:54]

We're lords of chaos.

Mostly Uncle Frank [10:57]

And in order to essentially ameliorate that problem, usually you need better diversification, essentially. But I think that's one of the challenges in adding leverage to a drawdown portfolio. It's this kind of like a double whammy on this potential volatility drag. I don't think it's nearly as much of a problem if you're talking about an accumulation portfolio, because that has the opposite effect. If you are adding money into a portfolio, it naturally reduces the overall volatility of the portfolio because it's essentially like having this big pile of cash on the side that you are feeding into this thing.

Voices [11:32]

There's $250,000 lining the walls of the banana stand.

Mostly Uncle Frank [11:37]

Now, a couple other resources and references we've talked about before. One we did cite a paper once about the optimal leverage as far as ETFs in a portfolio was concerned, and the author of that article came out to a value of two. But I think they were talking about more of a static kind of portfolio, not a drawdown portfolio. The other reference that we've made is this site called Optimize Portfolios, which talks all about leveraged portfolios and leveraged ETFs used in portfolios, and I think that's a useful site too. Although I don't know that they've come to any grand conclusions about using these in a retirement portfolio. Now, more recently over the past few years, there have been variations on this theme, including what are called return-stacked portfolios now, which take off on the risk parity idea, but are combinations of various assets in levered forms and ETFs that you can kind of mix and match. And they've now put out six or eight ETFs and I think have a billion dollars in assets that they've accumulated over the past three years. That's Corey Hofstein and Rodrigo Gordillo, and that's an interesting concept or variation as well. Although they are not promoting those things for retirement portfolios. They're looking at them more as a way of essentially getting stock market-like returns without taking stock market-like risk. And so that OPTRA portfolio, the last one that we've created, we started in July 2024, is a return-stacked style portfolio and has effective leverage in it of about 32 to 45%, depending on how you count it.

Voices [13:19]

And it's gone. Poof.

Mostly Uncle Frank [13:23]

And it seems to be doing quite well in that formulation. If you look at something like that levered golden ratio portfolio, that's designed to have leverage of approximately 1.6 to 1%. The golden ratio. Which is similar to what is in a paper called Warren Buffett's Alpha, which talks about you can model the performance of Berkshire Hathaway as an application of leverage of 1.7 to 1 due to the way it uses the float of the insurance companies in that structure. Now that one has struggled a bit, but it's recovered, and it's mainly struggled simply because it had a very bad start date right before 2022, which really took a toll in addition to its original 7% withdrawal rate. So overall, this is something I'm very curious about, but I really do not have a definitive answer to. It's kind of like one of those questions about what is the optimal rebalancing strategy, and I don't think there's any one answer to that either, because it kind of depends on the whole makeup of the portfolio and the withdrawal strategy itself. I think that's probably true of a topic like leverage as well. That if you start with a conservative enough portfolio, some leverage is probably going to work pretty well. But if the portfolio is either too aggressive to begin with and you apply leverage to it, or you're just applying too much leverage, like that aggressive 50-50 portfolio, which I think applies too much leverage, you're probably not going to have good results due to this volatility drag. Anyway, maybe one of you listeners will figure all this out and tell us when you do. At least I hope you will.

Voices [15:01]

And uh after that I just sort of space out for about an hour until I'm space out? Yeah. I just stare at my desk. But it looks like I'm working.

Mostly Uncle Frank [15:13]

In the meantime, I will link to all of these resources in the show notes so you can check them out because this is just a very interesting topic and something I've been very curious about since I first ran across Risk Parity style portfolios back in like 2010. So hopefully that helps you a little bit. Thank you for being a donor to the Father McKenna Center, and thank you for your email.

Voices [15:36]

Next, occupation stand-up philosopher. What? Stand-up philosopher. I coalesce the vapor of human experience into a viable and logical comprehension. Dependence is a very good city. Very wonderful city, ancient city. You're gonna learn a lot of dependence. You wanna learn how to make a very ancient blind like this? Second off.

Mostly Uncle Frank [16:27]

Second off, we have an email from Andrew. And Andrew Wright.

Mostly Queen Mary [16:43]

Hello, Frank and Mary. I first learned about your podcast after hearing you on a Bigger Pockets Money episode and have slowly been working through all 460-plus episodes of your show ever since.

Voices [16:55]

Very sick man.

Mostly Queen Mary [16:56]

Thank you so much for the wealth of knowledge you have provided to us average DIY investors. I am 32 and still in my accumulation phase of life, but closing in on my first million dollars. As I begin to think about how my portfolio should look in the future, I have started to take note of how much money I have in each tax bucket. I have the unique opportunity to contribute to a Roth TSP 401k, so my after-tax Roth dollars make up about 45% of my net worth, while traditional dollars is only about 10%. The remainder of my portfolio is 40% in a taxable brokerage and 5% in cash. I am almost entirely invested in SP 500 index funds. My goal will be to eventually move towards a golden ratio style portfolio with 42% stocks and 26% bonds.

Voices [17:52]

A number so perfect, perfect.

Mostly Queen Mary [17:57]

My question. I know you've explained that we want to hold things like bonds in traditional accounts due to the interest they generate, but given my small traditional balance, I'm curious what your thoughts might be on adding more to traditional retirement accounts instead of Roth to set myself up for a more efficient portfolio later. Additionally, I was curious if you could explain a little more about your reasoning for fund selection to fill the small cap value spot, in particular AVUV, like you've recommended for Mindy's portfolio, versus VIOV like you have in the Golden Ratio portfolio. I believe I've listened to all your material on small cap value funds, but if I'm missing something, please feel free to refer me accordingly. Thanks again for all that you do. P.S. I have made a contribution to the Father McKenna Center. I passed out lunches to the homeless in the DC area through my church growing up, so I'm happy to help giving back in this way. Thank you, Sensei, Andrew.

Mostly Uncle Frank [18:57]

Well, thank you also for being a donor to the Father McKenna Center, Andrew, and thank you for your prior work in helping feed people around these parts in the past.

Voices [19:08]

For me and the Lord, we've got an understanding. We're on a mission from God.

Mostly Uncle Frank [19:16]

We've had a lot of activity at the Father McKenna Center recently with all of these disruptions in the government and the food programs there. We've had a lot more demand. And fortunately, we've had a lot more volunteers show up, and so we've been having hundreds of people hand out thousands of meals, and we appreciate all of the donations to allow us to buy more food. So thank you again for that.

Voices [19:43]

We don't have enough to eat.

Mostly Uncle Frank [20:42]

I wouldn't worry too much about how it's going to be managed on the back end. I think what you probably want to be more conscious of is where you are in the front end. And if your tax rate is high, either because you make a lot of money or you're in a state with a higher state income tax, you probably want to use those traditional retirement accounts to get that benefit up front. Because when you retire, the advantage of it is that since you don't have regular ordinary income coming from a job, you have a lot of flexibility as to how much income you actually show every year, depending on where the money is coming from. And that can be managed. So if you are in a higher income bracket right now, I would simply go for the traditional up to the limits you've got there. If you're Roth eligible, that's never a bad choice in the long run. Particularly since you can access those contributions to the Roth without penalty, even before retirement age, so that's got another built-in advantage to it. And I should say congratulations for closing in on your first million at age 32, because that is quite a nice accomplishment.

Voices [21:50]

All we need to do is get your confidence back, so you can make me more money.

Mostly Uncle Frank [21:55]

It wasn't clear what your timeline was right now, but there's no reason to be transitioning right away unless you were planning on living on that million dollars or something like that. But if you're still close to a decade away or some number like that, I would just continue to invest in your stock market funds. You might branch out into the other stock market funds that you plan to be holding in the long term, at least if you're putting that in any kind of a taxable account, just to make it easier to manage when you get there. But you certainly wouldn't be needing to put any money into bonds if you're not getting close to retiring or living off the money, I should say, whether you're retiring or not. One thing I would do if I were you is pick up the new book about tax planning for early retirement, written by Cody Garrett and Sean Mullaney, because I think it's gonna answer a lot of the questions you have and clarify in your mind as to the best choices in terms of where to put your money and then how you're going to access it later on. What you'll learn from that book is take as many tax advantages as you can get up front because you're gonna be able to manage it on the backside fairly easily, particularly if you're talking about a few million dollars and not more than $10 million. And yes, you can put bonds in Roths if that is where you actually have room for them. The truth is most people just don't have that large of a Roth account to work with, and so that space is relatively limited. Okay, and your last question was about the choice of small cap value funds. So when I set up the original sample portfolios, I really wanted to be focused on asset classes themselves and index funds that represented them and not get wound up in fund choices. So I intentionally picked essentially the most popular small cap value index being used today, which is the S P 600 small cap value index, and that is reflected by the fund VIOV and also the fund IJS. Now, funds like the Avantis Fund AVUV were relatively new at that time, and it wasn't clear how they were going to perform in relation to the index. The theory behind them, though, had been around for quite a while because this is from the DFA funds, and what DFA had been doing since the 1990s is taking essentially what would be like a small cap index and then putting a profitability filter on top of it to essentially get rid of the worst companies and modify the whole process so it's still algorithmic, they're still using a formula to generate it, but they're trying to be more efficient about it. So DFA had originally only offered its funds in mutual fund form, and the way their business model worked is that they only worked with financial advisors, so you had to essentially go to a DFA-approved financial advisor to get access to DFA funds. Now it's interesting, some of the people who were at DFA wanted to branch out and start offering regular ETFs, and there was a dispute or something. Anyway, some of the people left there, went and formed Avantis, and started issuing these ETFs that are essentially doing the same sorts of things. DFA has now got religion, if you were, and started offering its own ETFs because its old business model just didn't work anymore. This is part of the evolution of ETFs and why we're living in kind of a golden age that you're able to get cheaper and cheaper fun choices, good fun choices of a whole bunch of things that you didn't have access to before or were prohibitively expensive. And now these things are relatively cheap. You used to be paying like 1% for them, and now you're paying 0.2 in most cases. So over the past several years, AVUV has kind of proven itself when you compare it to the performance of regular small cap index funds as having some advantages due to its additional profitability or quality filter on it. And so that is why today I would say if you're going to pick a small cap value fund, that's probably one of the better ones you could pick. There's also a DFA version of that out there now. A good place to find these best in class kind of fund choices is the Merriman ETF website. They go and analyze these funds as well as a bunch of index funds and compare them and publish their findings every couple of years, essentially saying these are the best in class depending on what you want. So I would say there is a kind of growing consensus that at least in the areas of small cap value and international value, that these DFA and Avantis funds are at least slightly better than index funds after fees, and maybe substantially better. So that is what I would pick today, and it is in fact what we have in a lot of our personal accounts. But I did originally want to use standard index funds to show that the methodology behind this risk parity style investing was based on asset classes and not based on fun picking. Because the truth is there are a lot of good choices for funds, and that that is the tail of the dog, and not the real make or break choice when it comes down to things. You always want to choose asset classes first, allocate them, and then make fun choices after that. As the last thing you do, not the first thing you do. So hopefully that explanation helps. And thank you for your email.

Voices [27:42]

If you don't do your revision properly, you know what will happen.

Mostly Uncle Frank [27:51]

And Ian Wright.

Mostly Queen Mary [27:53]

Hi, Frank and Mary. Thanks for all the clarity and courage you bring to the world of retirement investing. It's much appreciated. I've been reading Bill Bangin's new book, and it got me thinking about withdrawal strategies, fixed rate with cost of living adjustments, fixed percentage, annuities, and so on. I like the idea of a lifetime inflation-linked annuity, longevity risk solved, predictable income, but I don't like handing over all my capital, paying high fees, or trusting one insurance company forever. So here's my idea. Let's say I'm 65 with a million pounds invested in a sensible risk parity style portfolio. I pretend to buy an annuity by taking the going inflation-linked rate, say 5%, and paying myself half of that, 2.5%, or 25,000 pounds a year with cost of living adjustment for essentials. Then for discretionary spending, I take a sustainable withdrawal rate, say 6%, and again use half, 3%, or 30,000 pounds, recalculated annually from the portfolio value. This way, my essentials are covered with a stable income and my discretionary spending adjusts with the markets. Is this a reasonable hybrid approach or am I over-engineering things?

Voices [29:13]

We have barb the jets, but cannot hold them for long. The grand shakes.

Mostly Uncle Frank [29:32]

He asks. That's what you have to do in theory because. Because you don't have any real expenses that you are working with or real life you're trying to fund. The way it actually works in practice is the other way around that first you figure out how much your life costs, then you divide that up into discretionary costs and mandatory costs, and then you figure out how your portfolio or other resources are going to cover those costs. So to me, what you are saying is that half of your annual expenses are of the mandatory kind, which are covered by this 2.5% you point to, and half are discretionary, which would be covered by the other 2.5 to 3%, I guess. And I found that's pretty close to the way things work out. The reality is that for most retirees, about 60% of their expenses are in the mandatory category, and about 40% are in the discretionary category. And that's pretty true for us. So I use what I call a 311 plan that 3% are designated for mandatory expenses. We have 1% that we call comfort expenses, and then we have another 1% that we call extravagances that can change every year. But I think that's probably as detailed as you need to be in terms of the actual division of the distributions. Because I can tell you we do not carve out 3% and plop it in like one account to pay mandatory expenses out of and then take the other 2% and put it in some kind of discretionary account. That we just put it all in one thing and spend it and then look at it afterwards to see that we're still kind of in line with where we thought we should be. Because obviously this changes from month to month as to where this money is actually going. So I don't think putting a rigid framework on it as you described is necessarily all that helpful. You can just kind of do it on a more flexible basis, just making sure as you go you can account for where the money is actually going. Because obviously if your mandatories increase by some amount, you're going to need to cut back on your discretionaries. Or if you have some catastrophe, you just may need to cut back on discretionaries anyway. But you have the ability to do that whether you put it into a rigid framework or just a flexible framework. The one thing I should say is that at least in the United States, we do not have lifetime inflation-linked annuities. Nobody will sell you one of those. You can have ones that are fixed in their increases, like a 1% or 2% or 3% added cola, but no insurance company will sell you one that's based on the CPI or something like that. We have our Social Security, which does that. And I do not know what you have in the UK, but we cannot buy such a thing here.

Voices [32:45]

Snap, snap, green, green, wink, wink, nudge, notch signal.

Mostly Uncle Frank [32:48]

I think we will be considering when we get to about age 70 whether we want to take some of our money and put it into a simple annuity or simple annuities to add to what we're getting from Social Security than to cover some kind of base or floor kind of expenses. But that decision for us is really going to be based mostly on how healthy we feel we are and whether we feel like we're going to be living a very long time, which in our families is a distinct possibility. So for us it's going to be more of a financial decision based on projected longevity than on any kind of cash flow management. So you are free to think about this in the way you've described, but I don't think it's necessarily necessary.

Voices [33:33]

Necessaire? Is it necessary for me to drink my own urine? Probably not. No. But I do it anyway because it's sterile and I like the taste.

Mostly Uncle Frank [33:45]

It is something that's good to think about, just to make sure that you've got all your ducks in a row. So thank you for your observations. And thank you for your email. But now I see our signal is beginning to fade. If you have comments or questions for me, please send them to Frank at RiskPartyRader.com. That email is Frank at RiskPartyRader.com. Or you can go to the website www.riskpartyrador.com. 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, a follow, a review. That would be great. Okay. Thank you once again for tuning in. This is Frank Vasquez with Risk Party Radio signing off.

Mostly Queen Mary [36:12]

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.