Mostly Mary [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 Voices [0:22]

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 seven of Risk Parity Radio. In today's episode, we're going to follow up on episodes three and five, where we discussed the history of risk parity portfolios. Today's episode is about how. How can a do-it-yourself investor implement risk parity principles in their own retirement or drawdown portfolio. How do we do this? We have three questions today to get at that. First, how do professionals construct and manage risk parity style portfolios? Second, what principles should we be following to construct our own do-it-yourself risk parity style portfolios? And third, how can we implement these do-it-yourself risk parity principles? First question, Numero Uno. How do professionals construct and manage risk parity style portfolios? Well, truth be told, they are all over the map. Some are very conservative, some are more aggressive, some are very aggressive, and they have varying results as a consequence of that. For example, and I'll link to this in the show notes, many risk parity portfolios only experienced a maximum drawdown in March of about 17 to 20%, which is about half of what the stock market did. But if you take a look at Wealthfront's version of a risk parity portfolio, it was one of the worst and it was down over 42%. And the reason for that is most of these portfolios get pretty complicated. For example, at Bridgewater, Ray Dalio talks about identifying 15 or 20 uncorrelated asset classes. Other hedge fund operators incorporate the trading of futures or options on commodities or volatility indexes or swaps on interest rates. That's actually what Wealthfront was fooling around with according to its prospectus and what probably got it into trouble. in March. There's even now something called the Dragon Portfolio, which has a trend following system for commodities and an options system for trading volatility. And we'll talk about that in one of these episodes in the future. All of this seems pretty daunting for the do-it-yourself investor. And it is. We can't possibly be expected to be doing all this sophisticated trading and research into 15 or more asset classes and a bunch of derivatives. That's not practical, it's not reasonable, and frankly, when you look at the performance of some of these funds, it's not even wise or desirable. So we need to do something a little different that somebody who is a do-it-yourself investor can handle and use to their advantage. Which leads us to the second question, numero dos, what principles should we be following to construct our do-it-yourself risk parity style portfolios? Well, first we need to focus on the main ideas. Now what are those? I'll give you three, three ideas. They are called the Holy Grail Principle, the Macro Allocation Principle, and the simplicity principle. The Holy Grail, the macro allocation, and the simplicity. And the first principle of risk parity investing for the do-it-yourself investor is what is known as the Holy Grail, according to Ray Dalio, who invented this. And I'll link to a short video from Ray Dalio to explain what he means by the Holy Grail in this context. The Holy Grail principle is that our main goal should be to find and combine the least correlated asset classes we can find. The Holy Grail principle is that our main goal should be to find and combine the least correlated asset classes we can find. If you do this, you can reduce your risk by half or even more without sacrificing much at all in your expected returns. So we are really looking for asset classes with close to zero correlations or better yet negative correlations. Because if you look at it the opposite way, when you have assets that are more than 60% correlated It's not going to work. More than 60% correlation, you will not reduce your risk in any significant way. And as Ray Dalio says, you could have a thousand different assets with 60% or better correlation, and it's not going to reduce your risk very much. So this is actually what happens. This is what happens when your portfolio is composed of mostly a bunch of different stock funds. You are not really seeing much diversification benefit in that kind of portfolio. That is because even though stock funds have different names and they have different stocks in them, at bottom they are all part of the same financial market, which is the stock market. But if we do find these uncorrelated asset classes and we do combine them, that's how we can reduce our risk. Then the next question is, well, how many of these uncorrelated asset classes do you really need? And the truth is, you'll get the most bang for your risk reducing buck if you have at least four or five. With more than that, you see some additional incremental progress, but the benefits tend to flatten out the more you put in there. And you can see this on the chart in the Holy Grail video. that the risk reducing idea or effect of this is very pronounced with the first few asset classes and then flattens out as you keep adding more. So having four or five good uncorrelated asset classes ought to be the basic goal for the do-it-yourself investor with adding some more being optional. Now, something that is negatively correlated can almost count double. That's really the gold standard when you're talking about diversification. A negatively correlated asset class will have an outsize impact on reducing risk. Which leads us to our second main principle for the Do-It-Yourself Risk Parity Investor, which is what we get from Jack Bogle and has been confirmed by many studies going back to 1986. And we call this one the macro allocation principle. The macro allocation principle says this, more than 90% of your portfolio's performance can be explained by its macro asset allocations. And let me repeat that, more than 90% of your portfolio's performance can be explained by its macro asset allocations. So what are macro asset allocations? Macro allocations are funds or assets that are all in the same big class. Stock funds are the most common. All stock funds are in the same macro asset allocations. No matter whether they're small, they're large, They're foreign, they are all in the same macro asset allocation. Precious metals, bonds, REITs, preferred shares, cash, those are several other macro asset allocations or macro allocations. I should put an asterisk by the bonds though, because different types of bonds actually perform like they're in different asset classes. But that is really the exception that proves the rule. If you look at what's in all of these individual macro asset allocations, you'll find that all the things in there are going to be highly correlated, which is why it is the separation of the macro asset allocations that drives this rule. So what the macro asset allocation principle says ultimately is that one 60/40 portfolio or an 80/20 portfolio or a 50/30/20, if you have three asset classes or a 40/30/2010, if you have four asset classes, is going to be 90% similar in performance to any other portfolio with the same mix of macro asset allocations. Basically, any 60/40 portfolio is going to be 90% the same as far as performance is concerned as any other 60/40 portfolio. So this same general principle can be applied to that 60/40 portfolio of stocks and bonds, or it can be applied to a more complicated portfolio, say a portfolio that's 40% stocks and 40% bonds and 20% gold, or to any other grouping or kind of portfolio you can think of. And what this means is that we really need to focus on those macro asset allocations and those percentages in the portfolio. Most of our effort should be on what the percentages, relative percentages are of the stocks, to the bonds, to the commodities, to the gold, to the REITs, or whatever else we are putting in that portfolio. And only a little bit of our effort should be concentrated on what is within each macro asset allocation. Yet today, what most investors do is the exact opposite. What most of us do is spend an inordinate amount of time picking stock funds, trying to find the perfect ones. and really mostly ignoring these other macro asset allocations or macro asset classes. The macro allocation principle says we need to reverse that habit. We need to pick a few good stock funds and keep them as diversified as possible, but not obsess over them and really focus on moving up to setting up the other asset classes in our portfolio because that is it's going to drive our ultimate returns. or 90% of them. Which leads us to our third principle for the do-it-yourself and risk parity investor. And this one we call the simplicity principle. I most recently heard this stated most succinctly by Rick Ferri in an interview at the White Coat Investor that also featured Paul Merriman. And they were talking about portfolio construction. And what Rick Ferri said was this. He said, Complexity is a cost, simplicity is an alpha. And let me repeat that. Complexity is a cost, simplicity is an alpha. Now what does that mean? Well, first of all, what he means by alpha is a benefit or an addition to performance and outperformance. Applied to portfolio construction, the simplicity principle means that you are better off not overdoing it with the number of funds and the number of asset classes in your portfolio. Because the more things you put into your portfolio, the more difficult it will be to manage. And the more difficult it is to manage, the more it will cause you to make mistakes. The more it will cause you to second guess yourself. The more it will cause you to try to time the markets, to put more in a hot fund and not put as much in a lagging fund. Or to not be consistent over time and rebalance the way you ought to. What this principle says is you need to keep it as simple as you can while still fulfilling the first two principles. So that brings us to our third Question, numero trace. How can we implement these do-it-yourself risk parity principles? First, let's consider these three principles together. The Holy Grail principle says we need to look for maximum diversification. We need to find asset classes that have zero or negative correlations to work with as our primary building blocks. The macro allocation principle It says we need to focus mostly on the percentages allocated to each of those big building blocks and not on the internal makeup of each block. And finally, the simplicity principle says we shouldn't use more funds than we have to in order to meet our goals. Okay, so what are the basic building blocks for maximum diversification? Let's start again by asking Ray Dalio. In another video that I'll link to where he's being interviewed, he breaks down this into the most very basic components. And he says, well, you need some equities, some stocks. You need some long duration bonds to balance out those equities. And you probably need some gold and some cash or short-term bonds, but not too much of those. And you can add other things. So let's start with those building blocks. The best way to analyze correlations is to use a correlation analyzer that allows you to just input whatever you have, whatever funds you have or stocks you have, and will spit out a correlation coefficient back to you, which are numbers between negative one and positive one. And you'll find a very good one and it's free and it's easy to use at the site called PortfolioVisualizer.com, PortfolioVisualizer. com, and we will be talking about that site more in the future because it has a lot of nice tools for the do-it-yourself investor to analyze their portfolio. If you go to the portfolio page at RiskParityRadio.com, you'll see some of the correlations for the components in the sample portfolios and those were derived and spit out of the analyzer@portfoliovisualizer.com so you get a feel for what that looks like. Now when you look at those correlation numbers, what do you see? When the correlation number between two funds or assets is close to positive 1, that means the assets are correlated. So those two things tend to go up or down together. most of the time. Now, if the correlation number between two assets is zero or close to it, that means the assets are uncorrelated. And that means they really don't move together at all. Sometimes they could go up together, sometimes they go down together, sometimes they go the opposite direction. And when that correlation number is negative, It's down towards negative one. That means that the assets are negatively correlated. So what that means is when one of these assets or funds is going up, the other one is usually going down and vice versa. And then you can lay all these out, all your funds or asset classes out on a kind of a correlation spectrum. And when you do that, If you're going left to right, say, from negative one to one, what you find is this. Almost all of the stock funds are on one end of that spectrum, on the right side, towards positive one. And that's because they are highly correlated. They move together. On the other end of the spectrum, you'll find long-term treasury bonds, often the negative numbers there, the furthest negative, the furthest to the left. And those are the most negatively correlated with stocks. So when stocks go down, those tend to go up. Everything else is somewhere in the middle between those two ends. Gold and commodities are near zero. They're basically uncorrelated with stocks and bonds. Cash and short-term bonds are also near zero. REITs and preferred shares and many other things, master limited partnerships, those are slightly correlated with stocks. A lot of them are hanging around there around positive 0.5. So once you have laid all those out there in that spectrum, you are ready to build your portfolio. Now virtually all risk parity style portfolios start with the two ends, the stock funds and the long-term treasury funds. These are your base because they have that nice negative correlation which reduces the volatility the most in your portfolio. The stock funds provide the highest returns and the treasury bonds balance them out as Ray Dalio has told us. So those two macro asset classes usually comprise more than half of a risk parity style portfolio. And usually the stocks are a little bit more than the bonds, but you could have it the other way depending on what else you put in there. Now to that base you add your other macro asset classes. Maybe you add some gold, maybe some commodities, maybe some preferred shares, maybe some REITs, maybe some cash or short-term bonds, maybe some other things. It's okay to get creative here. And you give each one of those an allocation, a percentage of the entire portfolio that will be fixed for that macro asset class. And you want, obviously, all of them have to add to 100 in the end. So if you go and look at our sample portfolios at RiskParityRadio.com on the portfolio page, you'll see that each one has a mixture of these along with the stocks and long-term treasuries. And some have just one of these extra asset classes. Most have two, some have more than that. Well then what do you do? Well then after you put this thing together, you have to go test it. you want to go run it through the calculators over at another website called Portfolio Charts. And we'll probably have a whole episode about that. And you want to run it through the backtest calculators and the Monte Carlo simulators that are also at Portfolio Visualizer. Now all of this is free and it's easy to do. It's basically point click fill in the templates as to the percentage of each of the asset classes you have chosen, and then poke the button and let it do its thing and it'll kick out the results. So what are you looking for in these results? Well, you do want to know what the compounded annual growth rate is has been in the past for these portfolios, obviously, because it needs to support a withdrawal. And you also want to look at the projected maximum drawdowns. How painful might this portfolio be if you were to hold it? How far is it likely to go down in a bad market? And how long is it likely to stay down there? But what is most important for your retirement or your drawdown portfolio is the projected safe withdrawal rates. How much can you comfortably take out of your portfolio during retirement? Because if you are living off your portfolio, you want to know with some confidence how much you can take out each month, or each year, and how long is that going to last? How long are you going to be able to do that? So what is a good projected safe withdrawal rate for a risk parity portfolio? I'm sure most of you have heard of the 4% rule for average stock bond portfolios, but what's a good projected safe withdrawal rate for a risk parity portfolio? I would say it's at least 5% for a 30-year retirement. Otherwise, you're probably wasting your time. And you should go back to the drawing board and come up with a different mix for your portfolio. Now, if you have a portfolio with a 5% projected safe withdrawal rate, you will be 25% better off than someone who has a stock bond portfolio with only a 4% projected safe withdrawal rate. This is serious business. This is serious in making your retirement better. Either less money to accumulate or more money to use. Now closer to a 6% projected safe withdrawal rate. That is a gold standard goal for a do-it-yourselfer. With a 6% projected safe withdrawal rate, you would be 50% better off than someone who has a stock bond portfolio that only has a 4% projected safe withdrawal rate. Now, you may not want to be taking 5% or 6% out of your portfolio in retirement. But even if you only wanted to take 4%, even if that's all you were comfortable with, a risk parity style portfolio gives you a huge margin of safety. You are not butting up against the limits of the portfolio. And who wouldn't want that? Who would not want a huge margin of safety? Now, finally, I've just laid out the process for you. But if you're looking for a shortcut, the easiest thing to do is go just start with our sample portfolios on the website. It's easy enough to take them and put them in the calculators to see how that, how the calculators work. And then you can take them and modify them and put different asset classes in there. And you can put in whatever asset classes suit you or whatever asset classes you are interested in. This is not such a one size fits all that you can accommodate just about any asset class in one of these kinds of portfolios. And with that, I now see that our signal is beginning to fade. So tune in next time, which should be this Sunday, for our weekly portfolio review. This week's feature portfolio will be one of our experimental portfolios, the Accelerated Permanent Portfolio. And again, you can find these portfolios at the portfolios page at www.riskparityradio.com. Thank you for tuning in today.

Mostly Voices [23:49]

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.