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 64 of Risk Parity Radio.

Mostly Uncle Frank [0:44]

Today on Risk Parity Radio, we are going to dip into our mailbag for some questions, and then we are going to discuss some meta concepts surrounding Risk versus uncertainty and how rules of thumb can be used to deal with those problems. Man's got to know his limitations. But first, I wanted to thank all of our listeners and all of our new listeners. It looks like this podcast has increased in its listenership by about four or five fold over the past week. If you're just here for the first time, welcome. Thank you for coming to my Field of Dreams, my little podcast I built in the middle of a cornfield. It's good that some people will stop by and I hope you get something out of it. And if you're not ready for it now, perhaps sometime in your future it will be of more interest to you depending on where you are on your journey to financial independence. But let's just take a look at the mailbag. First one comes from Chuck H. Chuck H has a short message. He says, I just listened to the RPR podcast for about five hours straight on a bike tour. I love it. Thank you, Chuck, for that encouragement. I hope you did not crash your bike while you were listening to me rant about various things, but I'm glad you enjoyed it and I hope you will continue to enjoy it on your bike rides. I also like to listen to podcasts on a bike ride as well. And now let's go to our next question. This one comes from Tim L. And Tim L writes, hi Frank, I love your podcast, especially those that dissect each asset class. It is very insightful and different from other finance podcasts I listen to. I have a few questions relating to bonds in the current market. I am thinking if I should include bond per end TLT in my portfolio because of its negative correlation. I'm in my accumulation stage and want to reach FIRE in 15 years. Under the current low interest rate and years until I need to start my withdrawals, is it Necessary to introduce asset classes that have low risk and correlation with stocks? Question, would it be better to introduce TLT when I am five years away from FIRE or about that? Is there any benefit to owning bonds now? Wouldn't we expect the TLT price to drop as the only path for interest rate is up? Thank you for your advice. regards Tim. Well, Tim raises several questions. Let me address them in a couple of orders here. First of all, if you are in your accumulation phase and you are, he says he's 15 years from fire or you're 20 years from fire, you're some long time away from getting to financial independence, then no, you do not need one of these kind of portfolios. these portfolios are designed to be withdrawn or drawn down upon, and so they would be useful if you were saving for something in their intermediate term range, say five to ten years, you could use one of these portfolios. But if you were truly in your accumulation phase, you are probably better off simply going with those 100% equity style portfolios, whether you just do that in one fund or a few funds is up to you. Now the only caveat to that and the reason why some people would prefer to have some bonds in their portfolio is just the roller coaster ride of it. That whatever portfolio you choose to hold, you need to be committed to holding it through some downturns and they could be pretty serious downturns. So you could see after 10 years all of a sudden your whole portfolio dropped by 50 or 60%, depending on what kind of stock funds you put into it, and then you would be committed to holding on to that while it recovered. And so that is the only caveat that the best strategy for somebody in accumulation is simply to go with the highest growth assets that are not too speculative that are available. and it is a tried and true strategy simply to hold the S&P 500 or a total market index fund or some combination of funds, say adding small cap value or international or some other combination. And people like to get fancy with it, but honestly, and we'll talk about this a little bit more, a 100% stock portfolio will perform just like any other 100% stock portfolio to a degree of 90% plus. And this is the macro allocation principle that we have talked about that your macro allocation really determines how your portfolio is going to perform, assuming you're reasonably well diversified within portfolio. Obviously, if you only have five stocks, It's just going to be highly dependent on which five stocks you pick. But if you have 50 or 100 stocks or funds that hold many more stocks, any 100% equity portfolio is going to be about 90% plus the same as any other equity portfolio. 100% equity portfolio. This is a concept that people have a very difficult time absorbing. and it causes them to think that running around chasing funds or picking different funds every year is going to improve their performance. And it really isn't. If you want more on that, I would suggest that you read Jack Bogle's Common Sense Investing in chapters 18 and 19 in particular to understand that principle. And so then for Tim's next question, he wants to know when would he make the switch or shift into a risk parity style portfolio, and he's wondering whether five years would be a good time for that. And I think you could use a nice little rule of thumb that I often think about, which is when you're getting to five years out from your drawdown or when you expect to be drawing down from your portfolio, or anytime you actually hit your fine number and just want to solidify things. If your portfolio is at or near its all-time highs, you're not in the middle of a drawdown, that is a perfectly good time to switch your portfolio from an accumulation portfolio into a risk parity style portfolio. And you can do that all at once, or you can do it on some kind of a glide path. I do think that the glide paths you see in, for instance, target date funds are too extended that you don't need to have a glide path that goes over decades. You can have a glide path that goes over 10 years or five years or less, just so long as you really start thinking about making that shift when you're getting close. What you don't want to have happen is you take the chance of going all the way up to the line as to when you're going to retire, you haven't made the shift, and then all of a sudden there's a gigantic drawdown which changes your plans. And so making that shift at some reasonable point before you start needing or wanting to use that portfolio is my advice for that. And then his final question really revolves around predicting the interest rates for bonds. And he's wondering whether there's any benefit to owning them now, specifically long-term treasuries is what we're talking about, and is the only path for interest rates to go up? And actually the answer to that is no. Interest rates could go down again, and interest rates could go negative, and there are a lot of people who have written papers about this and devoted their careers to studying interest rates. And there's an ongoing debate as to whether interest rates are going to go up now or going to go down now. Really the point though of holding a risk parity style portfolio is that we get ourselves out of the prediction business. We don't really want to have to depend on our ability to think whether interest rates are going to go up or interest rates are going to go down or what they're going to do next. My experience is that interest rates go up and down in a kind of unpredictable manner. So the point of having a variety of asset classes is that you don't need to make that prediction. Because honestly, predicting which way interest rates will go is just as or more difficult than trying to predict which direction the stock market is going to go in the next few years. It's really an impossible task. I always find it interesting that people have this idea that they can predict interest rates where they are willing to accept that they can't predict the direction of the stock market. I guess because it seems so easy. There are metrics out there and you read things or hear things on financial TV about, well, this is the size of the debt and this is the size of the deficit. and there is a tendency to try and draw conclusions out of that, and that's just a bad process that you should not do that. And the people that have done that consistently have been wrong, and not just wrong now, they've been wrong last year, the year before that, the year before that, 10 years, 20 years, people have been wrong. When you know that somebody has been wrong, that long. If you look at somebody's track record who's been saying, well, we must, the interest rates have to go up. They have to because of this factor or that factor. You shouldn't believe those people because it's obvious that they don't have a good process for predicting things. Otherwise, they wouldn't have been wrong for 20 or more years. So I would suggest that we not try to predict which way markets will go in terms of interest rates, growth, recessions, those sorts of things. The idea behind a risk parity style portfolio is that it will survive and thrive in many of these kind of environments. And so the reason you're holding those long-term Treasuries is really not so much for the interest rate they are paying regardless of what it is. The reason you're holding them is that they will improve on their capital value by 20 or 30% when a recession hits. And that's what we saw last year and that's what we saw in 2008. And that is the repeated pattern for long-term treasuries. that over cycles, economic cycles, when the economy is in a recession and stocks are falling, long-term treasuries are usually rising. Now it doesn't fit that pattern all the time, every week, every day, every month. There can be correlations that persist over months. But over the course of years, that pattern has been consistent. And that is why these portfolios are one of the reasons why these portfolios survive in many environments and better than other portfolios survive. Along those lines, I was listening to a podcast from Paul Merriman today. It's the most recent one. I'll try to link to that in the show notes. where he was going through historical drawdown patterns using a portfolio that is essentially composed of only the S&P 500 and only treasury bonds going back to 1970. And he was talking about, well, what if you had a 3% withdrawal rate? What if you had a 4% withdrawal rate? What if you had a 5% withdrawal rate? A couple things that were interesting about this analysis that he did. First of all, he said, and I agree, that the bonds you should be holding for this kind of purpose, for the drawdown purpose, are the government bonds, are the treasuries. If you hold corporates for that purpose, you're not going to have the diversification, you're not going to have the negative correlation, and so you're going to run into problems with your Portfolio blowing up if you have a bunch of international bonds or a bunch of corporate bonds or worse yet high yield bonds, because all of those things are highly correlated with the stock market. So when you're thinking of a drawdown portfolio, as he says, you should really be thinking in terms of using treasury bonds for that. And then he went through historical run through of say a portfolio that was 100% Treasuries from 1970 and one that was 50% and one that was all mixes and he has evidently a table full of these or several tables full of these. And what he discovered that if you drew down at a 3% rate, all these portfolios would survive and you'd end up with a lot more money than you started with from 1970 to 2020. If you were drawing down at 4%, They were all going to survive some better than others. And in his analysis, if you drew down at 5%, a lot of them would fail. And that is really the point when we get to talking about why you want a risk parity style portfolio with some gold and some other things in it. Because if you look at the performance of a couple of our sample portfolios, like the Golden Butterfly or the Golden Ratio over that same period, You could draw down at 5% on those and they would have survived. You could have done it. You can't do that with other standard portfolios and that's the whole point here. We would rather have something that is more likely to survive a higher drawdown, even if we're only taking 3% or 4%. We want to have that cushion and that's the point of designing these kind of portfolios and why you would want to consider holding one in your drawdown phase. And now we'll get to a bit of theory and I want to draw upon an author who's a German psychologist named Gerd Gigerenzer with the Max Planck Institute and he writes a lot about decision making and decision making in different kinds of scenarios. And I will link to one of his videos on YouTube. He's got a lot of them. He wrote a book called Risk Savvy that I recommend if you're interested in how to make decisions under risky situations. And so what he gets into in this book and in some of his videos is the difference between risk and uncertainty. Now, the difference between risk and uncertainty is that risk you can calculate, whereas in a world of uncertainty, you cannot calculate your way to an answer that will be reliable for the future. Now, what does that have to do with investing? It has a lot to do with investing because the world of investing comprises both risk and uncertainty, and they're mixed together. But we do know for a fact that financial markets are uncertain. They're relatively unpredictable. And where he goes with that is an interesting place. What he says is this, look, if you're in a world of risk, like you're talking about rolling dice and you know what the odds are and you can calculate them, then you're better off just calculating them and getting as much data as you can find. and calculating away. But if you are in a world of uncertainty where you cannot compute the odds, then you are better following heuristics or rules of thumb. Now, rules of thumb seem like they are primitive, but what they give you is a measure of safety. Now the problem with us human beings is that we are always searching for certainty in an uncertain world and so we end up fooling ourselves as to whether we can come up with that certainty. We end up over analyzing past data trying to predict the future with it and it just doesn't work. And in fact the more data you throw into one of these prior analysis and the more optimized you are for the past, the more likely that you are not going to have somebody that something that works in the future. I'll just read part of this book because I think it's interesting to contemplate when you're thinking about risk and uncertainty and the psychology of it. Professor Gigerenzer writes in his book Risk Savvy, the quest for certainty is an old human endeavor. Magic cults, soothsayers, and authority figures who know what's right and wrong are its proponents. Similarly, for centuries, many philosophers have been misled by looking for certainties where none exist, equating knowledge with certainty and belief with uncertainty, as John Dewey, the great pragmatist philosopher, pointed out. Today, modern technologies from mathematical stock prediction methods to medical imaging machines compete for the confidence promised by religion and authority. The quest for certainty is the biggest obstacle to becoming risk-savvy. While there are things we can know, we must also be able to recognize when we cannot know something. We know almost for sure that Halley's Comet will return in the year 2062. but we can rarely predict natural disasters and stock crashes. Only fools, liars, and charlatans predict earthquakes, said Charles Richter, namesake of the scale that measures their magnitude. Similarly, an analysis of thousands of forecasts by political and economic experts reveal that they rarely did better than dilettantes or dart-throwing chimps. The quest for certainty is a deep human desire. The dream that all thinking can be reduced to calculation is an old and beautiful one. In the 17th century, the philosopher Gottfried Wilhelm Leibniz envisioned establishing numbers or symbols for all ideas, which would then enable determining the best answer for every question. That would put an end to all scholarly bickering. If a dispute arose, the contending parties would settle it quickly and peacefully by sitting down and saying, Let's calculate. The only problem was that the great Leibniz never managed to find this universal calculus, nor has anyone else. And Professor Gigerenzer calls this the zero risk illusion. the idea that we can eliminate risk through calculation, which is just wrong and has been actually proven to be wrong mathematically, although I won't get into that. Now, how does this play into investing? I'll give you a good example that comes from his book. Now, the father of modern portfolio theory, Harry Markowitz, invented a system of calculating using risk to come up with the most efficient model for constructing a portfolio. But the question then becomes how can you use that? And the answer is you really can't to the nth degree because of this uncertainty idea that the data you have is always going to be about the past. And so you get an idea or a feel for how things work. but it's not going to predict the future. And one of the calculations that he came up with suggested that you would need to have 500 years of data before you could accurately use modern portfolio theory to construct a portfolio of stocks that was balanced in all of the correct ways for maximizing efficiency. Obviously, you can't do that, which begs the question, well, how does Harry Markowitz organize his portfolio? And what he does is he uses a rule of thumb, a heuristic. Basically, he says, you know, I don't know what's the right proportions for these things. I think they're all kind of equal. And so he uses 1/n as his basic model, that if he's got 10 things he wants to invest in, He divides by 10, puts 10% in each one. Now this is from the guy that won the Nobel Prize for Modern Portfolio Theory, relying on a heuristic or rule of thumb. And he's a smart man because the heuristic or rule of thumb is going to do better in most circumstances over time simply because it's going to keep you on the road and avoid those drawdowns. And we can think of more examples of how that would apply, a lot of it using the allocations we have, the rebalancing rules we have. All of these tend to be simple heuristics or rules of thumb designed to keep us on the road And they won't get us there the quickest, they won't make us the most money, but they will make sure we get to our destination or stay where we are, where we want to be with them. I will be following this up to talk more about how those things apply in this analogy of driving, but we'll do that in another episode, not the next one, but probably the one after that. Because right now I see our signal is beginning to fade and it's time for me to say goodbye. We will be picking up this weekend with our weekly portfolio review of the six sample portfolios that you can find at www.riskparadioradio.com and if you have questions or comments I welcome them. You can send them by email to frank@riskparadioradio.com that's frank@riskparadioradio.com www.riskparityradio.com or you can go to the website www.riskparityradio.

Mostly Mary [25:24]

com fill out the contact form there and I will get your message that way thank you so much for tuning in 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 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.