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.

Mostly Uncle Frank [0:36]

Thank you, Mary, and welcome to episode 66 of Risk Parity Radio. Today on Risk Parity Radio, we are going to follow up on what we were talking about in episode 64, which is the difference between risk and uncertainty, and why rules of thumb are the preferable ways of dealing with uncertainty. And then we'll expand that into an analogous discussion of portfolio construction in retirement. I guess first we should go back and define what we mean by risk and uncertainty. Risk is a situation where you know what the odds are. and you can calculate outcomes based on those odds. Uncertainty is the situation that we usually encounter in the real world with respect to weather and earthquakes and investing, where you cannot calculate the odds. There are certain factors and things that no matter how much data we have, we'll not be able to calculate it because it's going to be based on random events and on complex behavior of all kinds of different people and circumstances. And that's really the kind of world we're dealing with when it comes to investments and financial investments. It's not completely chaotic or unpredictable, but it's uncertain to a high degree. So, as I said, in that world, where you're just dealing with risk, you can calculate your way out of it if you have enough data. The more data you have, you can calculate it. If you do that process in a world of uncertainty though, as we learned last time, you'll only end up describing the past. And you'll describe the past very accurately, but the chances of that describing the future actually get less and less the more specialized and the more data you put into that. And I'd like to refer you back to episode 49 on what's called the bias variance dilemma to understand why that's the case. That the more variables you stick into a data analysis from the past, the more unlikely it is to describe the future. The fewer variables you need to rely upon, the more reliable that projection is likely to be. And this is one of the reasons why we go with the simplicity principle for our portfolios. We want fewer inputs into our portfolios because it's more likely to yield a more consistent result that we can rely upon in the future. And so what we're getting to here is why using these simple rules of thumb gets you more predictable results in investing and thinking about what those rules are in our portfolio constructions. Now, one of those rules is what we call the macro allocation principle, which we talked about back in episode seven. And this is best described actually in Jack Bogle's Common Sense Investing in Chapters 18 and 19. And everybody should read that book at least once if they hadn't. This is something that is not well appreciated though by most amateur investors. And what the macro allocation principle says based on analyses of thousands of portfolio managers is that portfolios that have the same macro allocations, for instance, and what I mean by that is a 60/40 portfolio, that's 60% stocks and 40% bonds. All of the portfolios that have that, that are otherwise reasonably well diversified, will perform 90% the same. And so, getting those macro allocations right for what you're trying to do is what's really important. What's not very important is the micro allocations within those macro allocations. So all of those stock funds you're thinking about picking around, that's really not the important part. The important part is what is the percentage in stocks? What is the percentage in bonds, Treasuries in particular? Other bonds, if you're going to use them, but they act like a separate allocation. What is your percentage going to be in something like gold? And then what are your percentages going to be in other types of asset classes that will be performing differently and are uncorrelated with the other assets you're using? And so that is a rule of thumb that you are picking macro allocations for these asset classes and deciding, okay, I'm going to have 20% of this and 20% of that. and 20% of something else, and then fill out the rest. Why do we do that? Because that rule of thumb happens to work. This gives us a consistent and stable portfolio. The other rule of thumb that we use in portfolio construction and management is rebalancing, and we've talked about that in several episodes. Now, you can do that by calendar or by bands. and we talked about that, I think, last episode, episode 65. But what we also learned from that is if you do it too often, you don't get good results. And again, you're using a nice little rule of thumb that happens to work and has worked in many different constructions of portfolios over many years. And so that is why you would want to adopt such a rule of thumb. Now, what is the alternative to doing the way we construct portfolios? The alternative would be to take data that you collect every day, as much data as possible about interest rates and economic forecasts and unemployment and everything about the stocks or the funds that you're holding. And you can imagine getting thousands of parameters and sticking them into some big calculator every single day. and recalculating and recalculating and coming up with a different portfolio allocation every day and making a micro adjustment for all of these things. What the risk versus uncertainty models tell you is that that would not work very well. It not only would be time consuming and expensive, it's not likely to get you good results because you're really modeling the past with that, with lots and lots of parameters. So, if you try that, and people do try that, they try that by looking at funds that performed the best last year. And let's get some of those, and let's get some parameters that are based on small data sets, or even stories that go into these things. And that's what happens when people start making all kinds of adjustments to their portfolio for all kinds of reasons. which represent more data points and more calculations, that kind of portfolio or that kind of management of a portfolio has shown to underperform even the indexes that the investors investing in. And that's why amateur investors who make lots of adjustments to their portfolios typically underperform what they are holding by 2% to 4%. simply because they're jumping in and out at the wrong times based on some calculations that may be changing all the time. Trying to act like they're in a world of risk and these things can be calculated and are predictive of the future when they're just not. Because we're talking about a world of uncertainty where you don't know how that parameter might have affected the performance of your stocks or your portfolio some way in the past, say, you know, interest rates went up this much in 2010 or 11, and stocks did this. If you were to take that parameter and try to employ it or apply it in a different time period, you're likely to have bad results off of that. Because in a world of uncertainty, while you might be able to identify the relevant parameters, the effect they have or lack of effect they have is going to be different in different time periods. And that gives you that level of uncertainty that even if you knew all of the relevant data, you wouldn't be able to tell how that data would affect the performance of your portfolio or individual stocks in a predictive manner. And so that is why we come back to these rules of thumb, have these rules of construction, which are likely to give us a reliable performance. Now let's expand upon that and talk about the 4% rule, which is another rule of thumb, but there's a question as to whether it's a good rule of thumb or not, at least how it is applied in the original paper written by Bill Bengen, and it was written in October of 1994. We're going to link to that in the show notes because there's a lot of misinformation about what that rule actually is, what the assumptions were, and why it might not be appropriate for reasons that are actually stated in that article. One of the problems we have with evaluating things like that is relying on secondary sources, things we heard people say. You don't want to do that. We live in a world the age of steel, I like to call it, where the resources available to an amateur are much better than what was available even to professionals. And so we can get on the internet and search and find that original paper, read it for ourselves and understand exactly what it meant, and we don't have to rely on some secondary source as to what that means. So what was the rule that he applied there? It's a very odd rule. It says that you're going to take your portfolio to begin with and you're going to start using 4% of that in your first year. And then you are required to continue spending at least that much or more. In fact, we're going to adjust it by inflation every year and raise it. So it starts at that 4% and just keeps going up. and it's unrelated to the performance of your portfolio after that. It's unrelated to what your actual expenses are. You are required to spend that much money. And it sounds strange, and it is strange, because nobody actually lives that way. But let's think about this in an analogous way. Suppose we thought about your Retirement portfolio, the assets that you had accumulated, and you are going to stop accumulating and start living on these assets. And suppose we analogize this to creating a vehicle with fuel, and it's got engines and it's got methods and it's a mode of transportation. And I think back to the movie the Road Warrior, where you had these people in this compound and they needed to leave the compound and they knew they weren't going to be able to accumulate any more resources from that source. It's like a little refinery in the desert. And so they all had to pack up and move and leave. And then of course, Mad Max shows up. It's all the same to you. I'll drive that tanker. Which is a great thing because they needed him to drive that tanker to be the decoy so they could get away. But let's talk about what they were doing and how that's analogous to what you are doing when you hit retirement, when you're going to start living on those assets. It's like this. You've got this vehicle, you've got this fuel. These are all your different accounts that you've accumulated. Maybe you have different kinds of motors, maybe you've got some solar going on there, you've got a lot of gas, but in any event, you've constructed something that will drive down the road. And what are your goals? Your goals are simply to stay on the road and not crash, and also to keep moving so you can go to different destinations because you don't want to be stuck without any fuel, without any money left. Now, what are your options while you're doing that? Obviously, you can rely on different fuel sources or different motors which are represented by the assets that you've accumulated, you can take out of different accounts, if you will, in different amounts, do some conversions and adjust the different pieces of the portfolio. But the other thing you can do is adjust how fast you are going. You can push on the accelerator and go a little faster, or you can lay off the accelerator and go slower. You can go slower if the weather's bad. You don't have to go at the same speed. So let's think about our principles of portfolio construction, how they apply into this analogy. The macro allocation principle is a principle that basically says we're gonna stay on the road. We're not going to drive off road. We're going to stay on the road and look at our maps and figure out how to get places from there. We're not going to go a straight line across the field. Rebalancing is like staying within the lines. If the road's got lines, you can just stay within the lines and keep going in that direction. But now let's get to the 4% rule. The 4% rule as applied by Bill Bengen is like having an accelerator that is stuck in one position and it keeps ratcheting faster and faster each year and you're not allowed to lay off the accelerator at any point in time. Now does anybody drive like that? No, they don't. So you should remember that when you're thinking about, well, how am I going to manage this? you're not going to manage it the way that it's assumed in that 4% rule. And Bill Bengen recognized this. He was making these simplified assumptions in his paper just to illustrate a point. But if you go to page 178, which is page eight of the paper, but I'll link to in the show notes, He writes this, However, the client has another option to improve the situation for the long term, and that is to reduce, even if temporarily, his level of withdrawals. If the client can manage it without too much pain, this may be the best solution as it does not depend on the fickle performance of markets, but on factors the client controls completely. his spending. Let me read that part again. It does not depend on the fickle performance of markets, but on the factors the client controls completely his spending. That is basically him saying, you can just lay off the accelerator if you're having a problem, your portfolio is not performing well. Don't take 4% plus inflation based on the first year, take something less. maybe 4% of whatever it is at that point in time. But this does relate back also to this idea of risk versus uncertainty. Because he says the markets are fickle, the markets are uncertain is what that means. Factors the client controls, those factors are risk. that your expenses are more like risk. And if you have risk, then you can go and calculate to come up with solutions that work for you. So, you know, if you're driving through a snowstorm, you drive slower. If the road is very curvy, you would drive slower. If it looks like there are obstacles, you would drive slower and move around them. All of that is to say when you are planning your retirement, you should focus really heavily in great detail on what your expenses are going to be and how you're going to manage that end of it. Because that is the end of this that you can really hone in on, that you can really manage a lot better then you can deal with the uncertainty of the markets. So you should use your energy, not in trying to come up with millions of parameters to stick in a formula to predict the markets, but with hundreds of parameters to try to predict your expenses. And if you can predict your expenses and manage your expenses, then you're not going to have trouble driving down the road with a stuck accelerator. And when you think about it, all three of our principles that we use for portfolio construction can go into this kind of analogy. Our simplicity principle says don't make your vehicle so complex that it breaks down. and you're unable to fix it, or it goes off the road for some strange reason. That macro allocation principle says stay on the road and stay between the lines when they're available. And our Holy Grail principle, which is about correlation, basically says have different kinds of motors that run on different kinds of fuel and that operate differently in different kinds of weather. and maybe some snow tires if you need them. And if you have a variety of things, you are more likely to do well on any kind of road. If your vehicle looks only like a sports car that can only handle dry, clean pavement, or it looks like a monster truck, which is only appropriate for dirt roads, then it's probably not going to do well in all conditions. You want something that looks more like an all-wheel drive vehicle or one of those things they constructed in the Road Warrior that allowed them to escape while Mad Max was driving that tanker. No deals. I want to drive the truck.[Enclosure] I also want to address some nice emails and questions I've got from Christopher B, from Mark B, and from Jeff B. It's a B kind of world. And then we'll follow up on this episode in another week with an email from Chuck H about what he's facing perhaps going into retirement in about three or four years and preparing for that with the various things he's accumulated. He has a interesting looking vehicle to drive off into the desert there. If you'd like to communicate with me, I invite your comments and questions. You can send them to frank@riskparityradio.com by email. That's frank@riskparityradio.com or you can go to the website and there's a contact form and you can fill it out there at www.riskparadioradio.com and I will get your message that way. I see our listenership continues to grow by leaps and bounds. It's beginning to compound in an exponential manner, at least for the moment. I'm sure it will smooth out into an S-curve at some point, but it's nice to see that. If you have a chance, please do leave me a review over at iTunes or wherever you pick up this podcast because that helps spread the word. Thank you for tuning in.

Mostly Mary [22:53]

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.