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 74 on Risk Parity Radio. Today on Risk Parity Radio, we are going to have a bonus episode.

Mostly Uncle Frank [0:48]

We're having a bonus episode because I got several interesting emails in the past couple days and I thought I would just go through them. Here I go once again with the email. And so here we go. The first one comes from Jayven S and Jayven S writes, hi Frank, I'm loving the podcast. I've been thinking about some of the same risk parity portfolio construction principles you are focused on and I love having your podcast as a conversation partner of sorts. I'm experimenting with a riskier, high leverage risk parity portfolio and I thought I'd run it by you. The portfolio is 37.5% UPRO, 32.5% TMF, 20% DGBP, and 10% XVZ. UPRO and TMF are three times SPY and TLT respectively. DGBP is two times gold. XVZ is a very interesting volatility ETN that is a blend of short-term VIX futures and mid-term VIX futures. The precise blend is adjusted daily on the ratio of VIX/VIX 3M. In addition to the prospectus, I found this article interesting and very helpful in understanding XVZ. I will link to that in the show notes. Functionally, it's a lot like VIXY, but it doesn't fade to zero as quickly, meaning it can be held for a longer period without it killing the entire portfolio and it's not performing well. about the particular asset allocation I chose. In Portfolio Visualizer, this portfolio could be approximated by SPY 112%, TLT 97.5%, GLD 40%, X 10%, cash X minus 160%. When you consider it this way, the portfolio is 43% equities, 37% long-term Treasuries, 15% gold, and 5% XVZ, which is extremely volatile without any leverage. Thanks for your consideration and thanks again for the great content you are producing here. Well, thanks for that email, Javen. You are certainly experimenting here. This is an aggressive, leveraged portfolio. I don't know how it will perform ultimately because as I've said when discussing the experimental portfolios, which are the Aggressive 50/50 and the Accelerated Permanent Portfolio on the Portfolios page at www.riskparadioradio.com. But anyway, those are experimental portfolios because these leveraged funds unfortunately are not designed for long-term holding. As it happens, UPRO and TMF at least have worked reasonably well since they were devised in 2009. they are more liquid than some of these other funds, but they weren't designed for this purpose. They are working okay in what they're doing right now. My concerns with this idea simply would be around that volatility fund XVZ. Those things just don't perform very well. I haven't found one that really works very well in a portfolio for any long length of time. So I would think that this portfolio might be better off without that in it, if you could rejigger it in some way. I'm also not sure about the DGP fund. Some of those funds that involve commodities and are leveraged do blow up, usually on the oil side, but sometimes the gold side is not as robust. It may work okay. The other issue may be just liquidity and how much these things trade, because the issue with some of them is that you get big spreads in the prices or have a difficult time getting in and out of them. I don't know whether that affects DGP or XVZ. But anyway, what I did just for comparison purposes is I went ahead and ran Portfolio analysis, comparing the Javen S portfolio to the aggressive 50/50 and the accelerated permanent portfolio. And I will link to these results in the show notes. Now, this only goes back to September of 2011, so it does not include a downturn like we had in 2008 or 2000 because these funds have not existed that long. your analysis is probably more robust than one that you described doing. But just taking a look at these, we see that this portfolio is somewhere in between those two sample portfolios. That the compounded annual growth rate for the Accelerated Permanent Portfolio over this period was 17.16%. The Javen S portfolio was 20.57% and the Aggressive 50/50 was 22.01%. 1%. The Javen S portfolio had a higher best year, but also a worse drawdown. So it's more volatile. It has a standard deviation close to 18% compared to 16% for the aggressive 50/50 and 14. 75% for the accelerated permanent portfolio. This translates into risk reward sharp ratios. Javen S and accelerated permanent portfolio are about the same 1.1. and 1.11, the aggressive 5050 has a better Sharpe ratio, a better risk reward ratio at 1.29 for this period. And I think that is all most likely connected with that VXZ fund or XVZ fund. VXZ is actually another volatility fund that is similar to that one. So I caution with all of these experimental portfolios, they are experiments. I would see if I could do something different about the volatility aspect of this thing because I just don't trust those that much. I also ran this not with annual rebalancing, but with balancing bands at 7.5% like we do at the sample portfolios. It gives a better result for all three portfolios for that. And that's what you will see when you go to this link in the show notes. All right, let's go to the next email. This one is from Tim E. Tim E writes, hello, I discovered you through your interview on Choose FI. I'm a long time listener of the Common Sense Investing YouTube channel by Ben Felix, who co-hosts the Rational Reminder podcast. He focuses on factor investing and risk adjusted return theory. In episode 76 of his podcast starting at minute 550. He says that risk parity backtests well but does not have a theoretical framework that justifies its disregard for risk-adjusted returns in its portfolio construction. A discount rate establishes a risk-adjusted expected return such that expected returns are based on risk premiums. But risk parity, he says, ignores or minimizes risk return in its quest to achieve risk parity across uncorrelated assets. For example, neither commodities nor gold have a discount rate, but these assets take up space in a risk parity portfolio because of their low correlation to stocks and expected behaviors under certain market conditions. Do you know if any theoretical work has been done that addresses Ben's criticism? Does non-correlation compensate for the absence of a discount rate and under what conditions? For example, does rebalancing within a risk parity portfolio make up for gold's lack of a risk premium. My own portfolio is factor aware and does hold some gold in long-term treasuries, but I'm reluctant to go full bore into risk parity since gold and commodities do not generate income or have an expected risk adjusted return. I would love to hear you address this concern in one of your podcasts. It'd also be great if you were a guest on the Rational Reminder podcast or Ben Felix became a guest on the Risk Parity Radio podcasts and you two discuss this. Thank you. Well, starting with the easy part, which is the last suggestion, I'm happy to appear on other people's podcasts. I am not set up to have guests on my own podcast, and I'm frankly too lazy to interview people. Man's got to know his limitations. For me, as a retired lawyer interviewing people or examining people, sounds like work. So I'd rather be on the other side of the microphone, if you will. And technically, I'm really not set up for it, at least not at this point in time. Man's got to know his limitations. But that being said, let's talk about some of these other things. First, I think we need to tease this apart, because when you are talking about Discounted cash flows, what you are talking about is a method of valuation. A discounted cash flow analysis is a method of valuation, and that can apply to anything that has cash flows, typically in investing that is a profitable company or a debt instrument like a bond. Now, that is not the only method of valuation, though, and that is not an excuse for not using something. Because if you read any valuation textbook, you'll find there are multiple ways of valuing things, whether they're artwork, gold, commodities, real estate, whatever you got, there is a way to value it. So that in itself should not be an excuse for not using something in a portfolio. This is why I like J. David Stein's framework and we use those 10 questions. for analyzing investments? Because the second question asks this question：whether something is an investment, a speculation, or a gamble. Now things that are investments are subject to a discounted cash flow form of valuation that you could use for that. Speculations are things like gold and commodities that have a positive expectation over time, if only because we know the dollar is designed to devalue over time. Gambles are things with a negative expectation and David Stein does a very good job distinguishing between those two things and keeping the gambles out of your portfolio and allowing only reasonable speculations within a portfolio in reasonable amounts that are not going to be too volatile and overwhelm the portfolio. Now, I did go back and listen to that episode 76 of that podcast. Unfortunately, it was limited to a discussion of what we call the All Seasons Portfolio, which is sample portfolio number one. And if you want to know more about that, go back to episodes 213 and 26, 213 and 26 of this podcast. That portfolio, I do not believe is actually very representative of the risk parity style of investing. It is what Tony Robbins thought was a risk parity style portfolio. Tony Robbins is not a financial guy. He's a motivational speaker. And so you have to recognize what the limitations of that were. Unfortunately, because he's very popular, that has become kind of a poster child for risk parity style investing when that is really not accurate. So what you need to recognize about that portfolio, it is extremely conservative. As I said, it will put you to sleep at night. and should not be how you evaluate overall risk parity style investing. And since the discussion there was limited to talking about that portfolio, I think it's kind of misleading to think that that is really a useful way of thinking about the academic research that has gone into risk parity style investing. And there has been a lot of academic research into risk parity style investing, particularly over the course of the past 15 years. And I will pull a Ben Felix on you and quote some academic papers. We will link to in the show notes if I can figure out how to do that. This one is called Will My Risk Parity Strategy Outperform? It is written by Robert Anderson, Steven Bianchi, and Lisa Goldberg dated March 27, 2012. from the University of California at Berkeley. And we'll just jump to the conclusion. And this reads, In this article, we examined a risk parity strategy of the type considered by pension funds, endowments, and other long horizon investors who turn to leverage in an attempt to elevate return in a challenging market. Over the 85-year horizon between 1926 and 2010, the levered risk parity Strategy we implemented returns substantially more than unlevered risk parity, a 60/40 fixed mix and a value weighted portfolio. And it goes on later in the paragraph to say, on the basis of a risk adjusted return or realized Sharpe ratio, unlevered risk parity dominated the study. Now, what does that mean in plain English? That last sentence means that the portfolios that we are constructing here are much superior to other portfolios. They dominate in terms of risk reward. Sometimes the problems though with an unlevered portfolio is that its overall returns are a bit low, which is what you see in that all seasons portfolio. So you really want to adjust it so it has the kind of returns that you need to support a retirement or safe withdrawal rate. what that paragraph was also talking about, a leveraged risk parity style portfolio. That is what hedge funds commonly do and what we are experimenting within the experimental portfolios. But there is this middle ground that we try to achieve that is a portfolio with a similar risk profile to a 60/40 stock bond portfolio, but that has superior characteristics in terms of lower drawdowns both in terms of how far it goes down and how long it stays down. And that is why our risk parity style portfolios have projected safe withdrawal rates that are higher than what other standard portfolios have. And that is what we have seen in our analyses here, which generally go back only to 1970 because that's the data we have. But you see this paper and there are other papers out there. It goes back to 1926. And so if you were looking for some more comfort there, there you have it. For a couple more references, we talked about these way back in episodes 5 and 7. If you really want to get the intro episodes to risk parity style investing, listen to episodes 1, 3, 5, and 7. But two other references. One is a chapter from a CFA Institute manual about multi-factor investing or multi-strategy investing. It's chapter four, which is called Risk Parity：A Silver Bullet or a Bridge Too Far. It's written by Gregory C. Allen. This was published in 2018. And on page 74 of this book, In this chapter four, we read, the fact that the previous 15 years have been characterized by two major crises in the global equity markets, a consistently upward sloping yield curve, and a general decline in interest rates made risk parity look like a particularly compelling option. Although concerns about peer risk and the use of leverage made adoption at the policy level untenable, many institutions carved out strategic allocations to risk parity in an effort to further diversify their portfolios. Practitioners have responded with a wide variety of products and assets managed across these strategies have steadily grown. Questions remain about the use of leverage, specifically leveraging fixed income during a period of rising rates or one characterized by a persistently inverted yield curve. Practitioners argue, however, that interest rate risk is but one of the many exposures in a well-balanced risk parity portfolio, and that the approach will ultimately show its worth over the long run by delivering on its promise of higher risk adjusted return. So what this is saying is, yes, this is the wave of the future. And if you don't understand it, you need to understand it. It's time to get on board. It is time to toss out the foolish consistencies of the past that are the hobgoblins of little minds. so that we can move forward and we can use this as do-it-yourself investors to construct better portfolios than financial advisors told us to do in the past. I realize the financial services industry isn't going to like that and has a lot of excuses about why they haven't jumped onto this and why they don't use it properly, but that's their excuses. We need to take care of ourselves. and that's what we seek to do here. And so I will also see if I can link to that in the show notes, as well as the all weather story article about the origins of risk parity style investing from Bridgewater and Ray Dalio. And I should conclude here that I am really not trying to criticize Ben Felix. I think he does a really excellent job of debunking a lot of nonsense you hear in investing about things like dividend stocks and other things like that. But his primary focus is on what is known as factor investing, which is something that is talking about all stock portfolios and that deals with things that you might want to hold in your accumulation phase or you might want to use for the stock portion in a risk parity style portfolio. What we are doing here is something a bit different. We are talking about portfolios that don't have necessarily the maximum returns, but are better in that risk reward ratio in terms of drawdowns in a retirement style portfolio. All right, third question. This one is from Julie T. Julie T. Writes, hi Frank, what a thrill to have an email read on a recent episode. I didn't even have a question. Now I do. While attempting to implement the Risk Parity Ultimate portfolio this week, I discovered that Vanguard no longer allows trading in UPRO and TMF. It is not worth the hassle to move accounts and I have sworn off Fidelity after years of customer service problems. Can you suggest Vanguard friendly alternatives that would provide some oomph in place of the two leveraged ETFs? Thanks. well, Julie, I don't know about all of Vanguard's rules as to what they will allow you to trade or not, but yeah, you can modify that portfolio. The UPRO and TMF are not that significantly large parts of that portfolio at 2. 5% and 5%, but what I would also do if you're going to get rid of those is also get rid of that volatility fund because in a great sense, the UPRO is there to make up for the fact that when things are going well, that volatility fund is going to be a drag and the UPRO makes up for it with its leverage built into it. But what I did for you is I went over to Portfolio Visualizer, took a proxy for that Risk Parity Ultimate portfolio and constructed you a couple of ideas that you can look at and tinker with. that modify that portfolio. So one of them I put in it 22.5% in Vanguard Growth ETF, 22.5% in a small cap value ETF, meaning 45% in basic stock funds. Then we have 15% in TLT and we put 10% in EDV. So that's 25% of the portfolio. So that is similar to what's in there already. And then as the alternative components, we have 10% in PFF, the preferred shares fund, 10% in VNQ, Vanguard real estate ETF, and 10% in gold. And so that gives you a nice portfolio with nice characteristics. I also did another variation of this. I really don't like those total REIT funds because They are kind of distorted in what's in them actually. As I've discussed back in the episodes we had about REITs, and I brought out a very large correlation matrix of many options for REITs. Choosing individual REITs here is not necessarily a bad idea because they are internally diversified. So one of the other options I gave you is I put in O, the Realty Income Corporation, instead of the VNQ in that fund, and this is also in this portfolio visualizer thing I did for you. And you'll see that that tends to perform a little bit better because O is less correlated with the rest of the stock market by itself. O is a nice rate because it pays monthly, and it has about 6,000 leases on convenience stores and Walgreens and things like that, so it's internally diversified. But take a look at that matrix. and poke around with some of those individual REITs, maybe take two or three of them and get a better mix than you'll see in, say, our sample portfolios where I just used that one REIT fund because I wanted to keep things simple for the purpose of those sample portfolios. Those sample portfolios are not optimized in any meaningful way, and that's intentional because I want to test them in a non-optimized format because the likely to be more robust that way. So looking at the returns on these portfolios that I constructed for you, and this only goes back to February 2008 because of how long some of these funds have been around, but we see a compounded annual growth rate for the modified risk parity ultimate of 9.95%. If you take out the VNQ and put in the O, it jumps to 10.49%. you get best years in the 20% worst years minus 10 for one of the portfolios minus 6. 6 is the worst year for that portfolio with O in it and sharp ratios of 0.86 for the period and 0.93 for the period so these are pretty stable and nice variations on these portfolios as you would surmise they do not have that oomph that those leveraged funds would give you. All right, fourth email. This one comes from Don H. Don H says, hello, I heard your interview on the Choose FI podcast. Recently I found out my portfolio was not as diversified as I thought. To use your food analogy, I had bacon, fatback, hog jowls, Prosciutto, chicharrones, pork chops and barbecue, AKA a basket of highly correlated items. Why does that remind me of this? I'll have the smiley face breakfast special.

Mostly Voices [25:07]

Uh, but could you add a bacon nose, plus bacon hair, bacon mustache, five o'clock shadow made of bacon bits, and a bacon body. How about if I just shoved a pig down your throat? I'm kidding. Fine. But the bacon man lives in a bacon house. Nothing like a bacon man in bacon land.

Mostly Uncle Frank [25:26]

All right, then you go on to say, looking forward to learning more. Also, have you listened to your podcast with headphones or earbuds on? Try it. The sound effects are deafening. Keep up the good work, Don. All right. Well, thank you for that email, Don. Yeah, I think it's surprising when the first time people take their portfolios and put them into a correlation analyzer, and usually they think they have a diversified portfolio and oftentimes that's not really the case and you can see those correlations that are too close to one for comfort and it tells you that you really probably need to consolidate that part of your portfolio and then add some things that are diversified if you are going into your drawdown phase. As for the sound effects being deafening, I apologize for that. I think I did not normalize them properly in the last podcast, but I do make some effort to try to normalize the whole sound so it does not blow up in your ear, well at least not blow up in your ear most of the time. Thanks again for that email. and the final email in this stack. This one comes from Jacob H. Jacob H writes, hi there, I just discovered your podcast after hearing you on Choose FI. I'm enjoying it very much. I'm 49 and approaching my FI number and 1.8 million in the next three years. I've been following JL Collins, so I'm very heavy in VTSAx. My allocations are 60% VTSAx, 10% VBTLX, 20% REITs and rental units, 5% cash, and 5% IRA annuity, which I was sold by USAA before I knew what it was. I'm curious. You talk about treasury bonds as less correlated to stocks than VBTLX, but J.L. Collins always talks about that bond fund as the only one you need. I'm getting nervous that I'm too exposed as I approach withdrawal phase. Thoughts? Thanks and keep up the great work. Well, I am sorry you're saddled with that annuity product but we all make mistakes. I have some small whole life insurance policies that are no better than glorified savings accounts but thankfully they're small. And yes, I do realize that JL Collins talks about VBTLX in A Simple Path to Wealth. Now, that is a great book and everybody should read it who is just getting started in particular. because it was written for his daughter who was needing to accumulate a retirement portfolio and VTSAX is one great way to do that. It is a weak spot in that book though talking about bond funds because it was more of an afterthought and the issue here is this that if you are using the 4% rule as your basis for analysis and thinking about your retirement fund that was based on a bond allocation that is all treasury bonds. And so if you're thinking that is the kind of portfolio you want to have, that is, you need to have treasury bonds. The issue with VBTLX is it's a mixture. And so it's got, I think, 30 to 40% in corporate bonds, about 40% in treasury bonds, and then the rest of it is in mortgage-backed securities. So it is A little more correlated with stocks than treasury bonds would be, which have that negative correlation. VBTLX is around a zero correlation. So in terms of diversification, you're going to be better off if you move that to treasury bonds. But honestly, it will probably work. Most of these things will probably work. We're just talking about tinkering around the edges. How can we make this a little bit better. There is nothing wrong if you have a portfolio that has a total bond fund in it. It's just not going to be quite as good as one that is balanced out with Treasuries. And this is also why Paul Merriman, if you talk to him and he look in his personal portfolio, all of his bonds are Treasury bonds for this very reason. So I would probably just shift that over to one or more Treasury bond funds and that would be that. I think the bigger issue here is the correlation or lack of correlation between your stock funds and your REITs. I would check that out. If you have rental units, that's great because those for the most part have zero correlation to the stock market, except in crazy downturn times when the whole economy is collapsing. But the standard REITs will have some kind of correlation with the stock market, VTSAX, and you should check that. And then the other thing you might consider moving into your retirement is making that stock portion of your portfolio that is all VTSAX right now a little bit more diversified. And the easiest way to do that is just to add some small cap value in there. And that can be enough just by itself. But what I really would invite you to do is take your specific portfolio, use the tools, that Portfolio Visualizer and Portfolio Charts, and do these analyses, a correlation analysis, some back testing, just get an idea of how this has worked in the past. This portfolio is fine for most people for most of the time. It's very well within the umbra or penumbra of useful and potentially good retirement portfolios. So I wouldn't be that concerned, too concerned about it. I just think it could be a little bit better. You could have the same reward with less risk by just tweaking a couple of things. But now I see our signal is beginning to fade. I did want to thank so many new listeners and the old listeners. This podcast has become way more successful than I ever thought it would become. We're up to something like number 39 in investing podcasts this past week with an average of over 700 downloads an episode, which is pretty incredible. Do I feel lucky? Do I feel lucky? Next time, I think, and I hope we will get to our analysis as suggested by one of our listeners of a long-term Corporate Bond Fund, SPL B, and we'll be using David Stein's 10 questions to analyze any investment to do that. If you have comments or questions for me, I welcome them. You can send them to frank@riskparityradio.com that's an email frank@riskparityradio.com or you can go to the website www.riskparityradio.com and there's a contact form and you can just fill that out and put in your message and I'll get it that way. It would also be helpful to me if you are so inclined to go over to Apple Podcasts and put in a five-star review. It will help get the word out even further and farther for those who are interested in this kind of content. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Mary [33:09]

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.