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 [0:37]

Thank you, Mary, and welcome to episode nine of Risk Parity Radio. In today's episode, we're going to talk about how to choose investments, about the process for deciding whether you want something in your portfolio or not. We have three questions today to get at that. First, what are good methods for choosing investments? Second, what is an example of a process for evaluating an investment? And third, how can we apply that process to a potential investment for our risk parity style portfolios? First question, Numero Uno, what are good methods for choosing investments? That's actually a very difficult question to answer. Because there's more than one good answer. So when you have a question like this, sometimes the easier and better way to approach it is to invert it. As Warren Buffett's right-hand man, Charlie Munger, says, Always invert, always invert. And he's famous for applying this method of thinking about questions. So let's invert it. So what are some bad ways to choose investments? Well, one bad way is to pick the hot stock or the hot fund. Many amateur investors make this kind of mistake. Unfortunately, this is encouraged by the way fund performance is reported. If you go look at a fund, you see a one to ten year return reported there. And many people think that they should look at that and make their investments based on what those numbers say. But this is wrong. One to 10 years is not enough data to make that kind of evaluation. And an investor who picks funds that way often falls into the trap of chasing what's hot now, which ends up doing worse in the next several years. And so amateur investors usually underperform the market by 2 to 4%. And this is one of the reasons why it is very unfortunate the way these things are reported, because really you want to have about 25 years of data to really say that one fund is superior to others that are investing in the same kinds of things. What's another bad way to pick investments? Relying on advice from conflicted or compromised individuals, sales people and non-fiduciaries. Most of the financial services industry is involved in selling products to the public, and that is their primary purpose to make money for themselves and their companies. It is not to provide unbiased advice to you, so you need to be aware of that. and you see a lot of this in some kind of magic button investing, buy this complicated annuity product and it will take care of all your problems. It'll be in the stock market part of the time and it'll be guaranteed in this way and you'll have this other thing and it'll take care of everything. Those sorts of siren songs lead people down bad roads and into choosing bad investments for them. that frankly just cost them too much money and are often very inappropriate for their circumstances. One saying on that that I'm fond of that comes from Paul Merriman. He says, the more heavily a financially product is marketed, the higher the commissions for the salesperson and the company. So those free steak dinners that you get cards in the mail for, those aren't free. Those are being paid for as part of the marketing and the reason they can pay for that kind of marketing is the fees and commissions on the products being sold are very high. There are no freak steak dinners for buying low cost index funds. There's a third bad way of investing. Investing blindly on free tips or recommendations, relying on ignorant individuals, something pops up, your uncle says, you should get into this. I'm into this. Somebody you've never heard of, somebody on the internet. Oftentimes these things look attractive. It looks like everybody's getting on board. It's not a good idea. Here's a fourth bad way of picking investments. Prognosticating on headlines or predictions about the future. Trying to get guess at future interest rates. Interest rates have to go up. Therefore, I have to invest in this or I can't invest in that. Or guessing about future tax rates or future election results these days or future anything. If your investment choosing is based on you being able to predict the future, you're not going to have good results. Why do people think this is appropriate? Probably because this is often what passes for news on financial news channels. They get a talking head on there. They ask them some questions about the future. He or she gives a prediction. Everybody goes, Ooh, wow. Nobody bothers to keep track of whether this person was right or wrong in the past. It's just a prediction and a prognostication. And that is often what financial news media is based on and why it's a good idea to ignore most of it most of the time. A fifth bad way of investing is to invest in things you don't understand. Somebody says, invest in this ticker symbol, XYZ. But what is it? Is it a company? Does it produce products? Is it a fund? Is it a fund that is a collection of companies or a collection of commodities or real estate investments? Is it a contract you're investing in? Are you reliant on somebody else to pay you some kind of income or fee from a company selling an annuity or a loan contract, you're loaning money to somebody? Is what you're investing in some land? Is it some other object? Is it a collectible? Is it artwork? Is it a gold coin? Is it Bitcoin? All of these things have characteristics and you need to understand what those characteristics are because if you don't, you don't really have a business investing in it. A sixth bad way of investing is having unrealistic expectations. You see some stock or something that went up 20% in the last three months. You convince yourself that, well, if it went up 20% in the last three months and Everything's looking good. I should be able to get at least that in the next three months, and I should be able to get 20% in three months all the time. Or you see somebody advertising forex trading, saying they're making 10% a month. Think about that. They'd be richer than Warren Buffett in a few years if you're compounding at 10% a month. It's not happening. It's an unrealistic expectation. Here's a seventh bad way of investing, treating investing like gambling, jumping in and out of various investments on feelings, hunches, or headlines. Or looking at spurious correlations. Here's a famous one, the Bangladesh butter indicator for the S&P 500. Somebody looked back and found out that the production and price of butter in Bangladesh was 99% correlated with the S&P 500. Would you decide when and how to invest in the S&P based on Bangladesh butter? No, that would be gambling. And an eighth way, taking unnecessary risks. When you have won the game, it's time to stop playing that game. If you have been investing all your life, and putting your money into lots of different stock funds and they get to a level where you don't think you're going to need to have to work again. You don't need to be continuing to take that kind of risk. It's time to take some chips off the table. It's time to put it somewhere else into something else because your risk profile changes over your life. You should be taking lots of risks when you're young and less risks as you get older. Which leads us now to the second question, numero dose. If these are the wrong ways to invest, what is an example of a good process for evaluating an investment? Well, a good process asks a series of questions. The idea is to try to be as objective as you can. And to try to avoid obvious mistakes. Maybe you want to structure this as a flow chart, or maybe you just want to ask the questions and answer them for yourself. Now the best process for the do-it-yourself investor that I've run across recently comes from a man named J. David Stein. Now David Stein has a podcast and a website called Money for the Rest of Us, and I highly recommend that. He is a former money manager with decades of experience. He is now retired and now devotes some of his time to helping do-it-yourself investors. And he does a good job with it. Now, just this past year, David Stein published a book called Money for the Rest of Us：10 Questions to Master Successful Investing. Now, this is based on his decades of professional experience investing in all kinds of things. And if you look at his portfolio, which he describes in the book, he owns about 15 different asset classes. But in those 10 questions, we find a process and it's a process that is objective and comprehensive. Okay, so what are these 10 questions? This isn't the only process you could follow, but this is a very good process for the do-it-yourself investor. 10 questions. The first question is, what is it? Is it a stock in a company? Is it a loan to somebody? Is it an object? Is it some kind of contract? The corollary to this, if you can't explain what this investment is to somebody else, you should not invest in it. Or you should take more time to learn about it so that you do understand it. Second question, would we characterize this as an investment? speculation or a gamble. And David Stein comes up with these three categories and they're very useful. Now, an investment he defines as something that earns money and has a positive return. Examples of investments are stocks and bonds, rental real estate, something that either is paying you money because it's a dead instrument, or it's some kind of business that is generating income. Now that income may be paid out or it may be going back into the company, but it is generating income. Now the second category he comes up with is a speculation. Now what is a speculation? A speculation is something that does not earn a return but has an intrinsic value that changes over time. Examples of this could be things like raw land, gold, currencies, commodities, collectibles, cryptocurrencies. All of these things are things you can buy and possess and then hopefully at some later point in time you're going to sell them because somebody else values them more than you did when you bought it. That's the idea of his speculation. And the third category, he puts things in our gambles. And gambles have negative expected returns. Examples are lottery tickets and roulette wheels, the sort of things you could think of that are like that. And there are a few negative gambles that are actually advisable in certain circumstances. For instance, insurance. Insurance is a gamble by you that something bad is going to happen to you. You really hope it doesn't, but if it does, you'll get paid on it. If you buy naked call options or put options, and some people buy put options in the stock market as a form of insurance, Those are essentially a gamble by themselves, but they're also a kind of insurance because you're figuring the stock market drops a lot, this will pay off. If not, I'm probably going to lose some money. So after you determine whether your investment is actually an investment or speculation or a gamble, what is question three? Question three is, What is the upside of this investment? Does it have an interest rate? Does it have a history of dividends or positive cash flows? Are its cash flows growing? Is it a growing company or is it a fairly stable company like a utility? Is it expected to grow in value in the future? Does it have a history of performance? How long is that history? How reliable is that history? Maybe some, maybe not so much. Fourth question, what is the downside? How volatile is this investment? Could you lose some money? Could you lose all your money? Is there a market that has market risk attached to it? It's part of the stock market, could it just go down because everything's going down? Is there a counterparty risk? Are you counting on a specific party to pay you, either because you loan money to them and you expect them to pay you back, you expect them to pay you rent, you are counting on some other party to pay you. And then is the risk concentrated or dispersed? If it's an individual stock, your risk is concentrated in that company. If it's a fund of 500 stocks, your risk is Disbursed. Your downside is lessened by that. Fifth question, who is on the other side of the trade? Are you trading in public markets? Are you trading against professionals? Are you trading against computer programs? Do you require some special knowledge to succeed in the area? That could be something like trading currency futures or Trading artwork. Sometimes you need to know a lot just to get involved in something. And in the counterparty circumstances, are you dependent on a counterparty? A company, a borrower, a tenant? Can you count on that party to pay you? Sixth question. What is the investment vehicle? Is it an individual security, like a stock or a bond? Is it an actual building that you're going to rent? Is it a fund? What kind of fund is it? Is it a mutual fund? Is it an exchange-traded fund? Is it a closed-end fund? Is it a partnership? Is it a contract? you need to know not just what it is, but how it works. Seven, what does it take to be successful? Can you just buy it and let the cash roll in? Do you have to do some research? Do you have to do some negotiating? Are you counting on it increasing in value? Are you counting on an invention or an approval? of some kind? Is there leverage or borrowing involved to increase the returns and the risks? Are you borrowing to invest in stocks? Are you investing in a fund that has leverage in it? It borrows to do what it does to increase its returns? Are you taking out mortgages or other loans to support the investment? Number eight, eighth question in the process. Who is getting a cut? Are there trading costs or fees associated with investment? Do you have to pay recording fees? Do you have to pay for lawyers or brokers or other commission sales people or some kinds of insurance? Are there commissions on this product? Are there advisory fees? and what are they? And who is getting them? Is there an expense ratio or other fees involved? And while you're considering that, are there lower cost options besides the ones being presented? Oftentimes the biggest mistake made is not looking beyond the menu of items that is presented, because there might be something out there that's better and cheaper. And what about the taxes? How is this investment going to be taxed? When will it be taxed? That's another cut coming out of your investment. Nine, the ninth question is how does this impact your portfolio? And here's where we get to the risk parity part of this. Here's where we get to the asset allocations. This may be the most interesting question for the risk parity style investor. And the questions are, is this asset similar to ones you already hold or is it different? Is it correlated with your other investments or is it uncorrelated or is it negatively correlated? Will it go up and down at the same time as your other investments go up and down? Can you assign a number for the correlation? How volatile is it compared with your other assets? Is it a lot more volatile or a lot less volatile or about the same? If you put this in your portfolio, will it increase or reduce the overall volatility of your portfolio? And how will it affect the projected safe withdrawal rate of your risk parity style portfolio. Last question, number 10, should you invest, knowing all of what you know, answering those nine first questions? And the questions are yes or no, and then how much? Usually it's better to ease into anything that is new, and there's no reason to bet the farm on anything. Now the third big question we're asking today, numero trace, is how can we apply the money for the rest of us process, the 10 questions to a potential investment for our risk parity style portfolios? Can we work through an example? I hope to address many asset classes in future episodes, but let's just focus on one today. We are going to consider an investment in a fund that holds Preferred shares. Preferred stock shares. The ticker symbol for this fund is PFF. Now let's go through these 10 questions. Many of the answers can be found in an article or two that I'll link to in the show notes. Okay, what is it? What are preferred shares? Question one. Preferred shares are a special kind of stock that companies can issue that is separate and apart from their ordinary shares. The ordinary shares are called common shares to distinguish them from the preferred shares. And so most of the stock investments you are making, whether through individual stocks or a fund, are investing in common shares. Now what's the difference between preferred shares and common shares? One difference is preferred shares do not have voting rights in the company. The second thing is that preferred shares typically pay high dividends. And typically the dividends on the preferred shares must be paid before dividends on the ordinary shares. And that's why they are called preferred. The preferred shares get the first cut of the income. And there is a preference to pay them first. Now in practice preferred shares behave kind of like a cross between a stock and a bond. They pay steady income like a bond, but they also trade like stocks. Second question, are preferred shares an investment, a speculation, or a gamble? Well, preferred shares pay an income and have a positive expected value. So we would characterize them as an investment and not a speculation or a gamble. Now, most of the companies that issue preferred shares are large banks and utilities like JP Morgan and Wells Fargo and Dominion Energy. And you'll also see companies like AT&T issuing preferred share. So these are large stable companies with a lot of money to pay a lot of dividends. And they pay a lot of dividends to their preferred shareholders. Third question, what is the upside? The upside of preferred shares is almost all in their dividends. Preferred shares pay dividends at a relatively high rate, usually in excess of 5% annually. And this is steady income. Most preferred shares payout every month. Another upside is preferred shares are easy to buy and sell on the stock exchanges. They are listed on the stock exchanges. You can buy them individually, and you can buy them in funds, which are diversified across many different companies' preferred shares. And so a fund like PFF has over 500 different company preferred shares in it. And another upside to them is they are not very volatile. The price of the shares does not move around very much compared with ordinary stock investments. They're relatively stable. What is the downside of preferred shares? Question four. Preferred shares typically do not grow in value like common stocks. Their value is all in their dividends, and so their upside is pretty much limited to those dividends. They don't have much appreciation. They are also not first in line if a company declares bankruptcy. The bondholders of the company would be the first in line to get paid, then the preferred stock shareholders, then the ordinary or common stock shareholders. And preferred shares can also decline in value. A preferred share will typically decline in value in two circumstances. One when interest rates are rising generally, and another when the common shares of the company decline and there is some danger to the company not being able to pay or the company is shrinking, then preferred shares will decline. And we saw this in March, preferred shares declined for most companies about half of the declines you saw in their common stocks. And now they've gone back up to where they were before, just like a lot of the common stocks have done. All right, question five. Who is on the other side of the trades in preferred shares? Well, most preferred shares are owned by institutions, like pension funds and insurance companies and other large pools of investments that need to generate income to pay somebody or some thousands of people. Now what this means is that the market for them is relatively stable and does not move around that much. But it's also very liquid. There's also a large market, institutional market for buying and selling preferred shares. Question six, what is the investment vehicle? Well, the investment vehicle we're talking about here is PFF. This is an exchange traded fund, or ETF. And the fund creator is iShares, which is one of the largest fund creators in the world. I'll provide a link to the iShares description of PFF in the show notes. And what they have done is they have bought over 500 issuances of preferred stock. and put it all into a fund. And the most that's in any one stock is, or preferred issuance, is about one and a half percent. And there are 452 million shares of PFF outstanding. It's widely held and widely used by lots of institutions and other investors. So because it's so widely held, PFF typically has a bid-ask spread of only a penny. so it's easy to buy and sell. The bid will be $33.10 and the ask will be $33.11, so it's easy to get in and out of. Now there are alternative ETFs that invest in preferred shares too. There's probably about a dozen ones that you can find. But PFF is the largest and it is the most liquid. and all of the expense ratios of these funds are pretty similar. Now you could also as an alternative invest in individual preferred stocks, but that would take another level of analysis due to the inherent risk in individual shares. And you would need to analyze each company and each share for each issuance. so it would be a lot more work than looking at a fund that's already diversified. Question 7, what does it take to be successful investing in a fund like PFF? Well, not a whole lot of effort is required. You basically just buy the fund and collect the dividends. And you'd be responsible for rebalancing into or out of it as it changes in your overall asset allocations. It's not a lot of work. But also, this is not something that you would speculate in. It is more of a buy and hold purchase. You would not want to sell out of it when it dips like it did in March. If anything, you'd buy more on the dips in a rebalancing move. Question 8, who is getting a cut here? Now, from the investor's perspective, the only real cut here is coming out of PFF is the expenses for the fund, and the expense ratio is currently 0.46%. which is not bad for a specialized fund. And since it's managed on an index, there are no additional management fees or load fees or anything like that. And since you can do commission-free trades at most of the large brokerages now, you're not going to be paying anything on that. So it's a pretty cheap way to get involved in 500 different preferred shares. And what about taxes? How is PFF taxed? Well, it's taxed like another dividend paying fund. So most of its dividends are qualified and will be taxed at the long-term capital gains rate, whatever it is for you. Obviously, if you buy or sell PFF, there will be also short-term or long-term capital gains. depending on how long you have held it. But it's really not any different from any other stock fund. Now question nine, how would PFF impact your portfolio? Well consider what role it would play. It basically would be there generating some steady income like a high yield bond. But you wouldn't expect much more out of it. You wouldn't expect it to grow or generate much more income than what it says at the coupon rate that it's paying at. Now to get at how it relates to other parts of your portfolio, we would have to consider how PFF matches up with the other things that you're probably holding in your portfolio. And we can go to the Portfolio Visualizer website and look at the asset correlations. for one measure. So if we compare PFF to a total stock market fund like VTI or VTSAX or any number of the large diversified funds, we see that it has a correlation of about plus 0.58. So it's partially correlated with stocks. And if we look at its past history in the charts, we see it's relatively stable, but it does take some dips when the stock market takes some big dips. And those dips are typically about half of what the stock market decline is. And then PFF has a tendency to recover with the stock market. So how does PFF compare with the treasury bonds we might be holding in our risk parity style portfolio? Well, it's a correlation with those that's close to zero. And that's a good thing. This puts PFF kind of in the middle of our correlation spectrum. If you had to treasury bonds all the way on the left and the stocks all the way on the right. This would be somewhere in the middle. And it would add a little stability to the portfolio because it's not as volatile as the stocks or long-term treasury bonds. Now, what if we compare it to another thing we might be holding in our portfolio that also pays income like REITs? It looks like PFF pays similar income to REITs and maybe a little more. PFF is currently paying about 5.4% annualized, and a big REIT fund like VNQ is paying about 3. 88% in comparison. And if you look at the correlations, the PFF and the REIT fund have positive correlations of about 0.56. So it's kind of like another REIT in there if you were to put it in there with your REITs. that pays a little more and is not quite as correlated. Well, what if we look at it and compare it to something like dividend paying stock funds you might be holding? Let's compare it with VYM, the Vanguard High Dividend Fund. Now that fund is paying about 3.6% annualized, but VYM is also highly correlated with the total stock market fund like VTI. It's about over 90% correlated. So PFF looks like it's a much better alternative to a dividend paying stock fund if you're looking at the overall impact of the portfolio, because it has a higher yield, but a lower correlation to the other things in the portfolio. What about corporate bonds? How does PFF compare to those? If we take a look at a couple of Vanguard corporate bond funds, VTC, for example. We see that they pay interest in about the 3% to 3.5% range, and they have about the same correlation to the stock market as PFF. So you're getting a lot bigger payout out of something like PFF than you would out of the corporate bond fund. Question 10, should you invest? Well, maybe if you were in your accumulation phase, PFF probably isn't much use to you because it's not going to grow as fast as stocks. It's limited. But if you're in your drawdown phase as the portfolios that we're talking about here, PFF will provide both income and stability to a drawdown portfolio, even though it's never going to be a primary driver. It's never going to grow like a stock fund. So what that tells you is you don't want to go overboard on it. It would be a minor portion of your portfolio. And if you did not already have something in your portfolio that generated income PFF would be a good option. It seems to be a superior option to either dividend stock funds or corporate bonds because it provides higher income with similar or less correlation to your stock funds. So it just looks better than they do. in a diversified risk parity style portfolio. And this is probably why some savvy investors have begun using PFF as a substitute or in addition to the bonds they might be holding in their portfolio. In particular, in an interview I heard the other week, Rick Ferri said that he had dumped some of his bonds for PFF instead precisely because he wasn't getting the kind of income he wanted out of these income bonds, these high yield bonds, or these corporate bonds, and PFF filled that role much better. And so what have we done with PFF? Well, we have incorporated it into some of our sample portfolios. In particular, you will see it in the Risk Parity Ultimate Portfolio, which is about 12. 5% PFF, the Accelerated Permanent Portfolio, where it's about a quarter of it, in the aggressive 50/50 portfolio where it's about 1/6 and it anchors or forms a very stable income producing part of those portfolios. And so that is an example of how to use a process to analyze an investment here PFF and come up with some conclusions as to whether It's useful for you. Now notice what we did not do in this process. Let's invert this again. We did not ask any gurus. We did our own research and it wasn't very hard. You can search on the internet. You can find things out. They're easy to understand, particularly for common investments like this one. We also did not gauge the investment by its popularity. We did not take a survey of 100 investors and see how many were invested in PFF. We did not care whether people were talking about this or not. It's a very boring institutional investment. Why would people talk about it? They probably wouldn't. And it didn't matter to us whether our friends had heard of it. All that mattered was our own questions, our own inquiry. And also what we did not do, we did not fixate on past results or try to predict how well PFF would do in the future or try to time the market to decide is it high now, is it low now. We did not consult any headlines. We did not consult macroeconomic indicators, look at the employment rate, the GDP. We did not start guessing about elections or taxes or legislation or anything like that. Instead, we looked at the pros and the cons of PFF on a long-term basis, and most importantly, how this might fit or not fit in our portfolio with our other investments. And that is the basis that we decided whether it was good enough to include. And so this is the kind of process we will want to follow whenever we are considering an investment. and hopefully we will be applying it to more investments in future podcasts. And with that, now I see our signal is beginning to fade. So tune in next time, which should be this Sunday, for our weekly portfolio review. This week's featured portfolio will be one of our experimental portfolios, the aggressive 50/50. And again, you can find those portfolios on the Portfolios page at www.riskparadioradio.com. As always, if you have any questions, please feel free to input them on the page or you can email me directly：frank@riskparadioradio.com. That's Frank@riskparadioradio.com. Thank you for joining me today. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Mary [38:11]

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.