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 [0:18]

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 90 of Risk Parity Radio. Today on Risk Parity Radio, we're going to try to make a dent in some of the messages that have piled up and all the questions from our listeners. So let's get to it. Here I go once again with the email.

Mostly Voices [0:56]

First off.

Mostly Uncle Frank [1:00]

And our first email is from Melissa W. And this is actually her second email. And Melissa writes, Thank you. I wonder if you would have time to help me understand something recent which has me confused. Today the Dow went down almost 700 points. This is May 12th. S&P and NASDAQ also varied down, so I expected TLT would be up due to the negative correlation you have described. However, I see it as down over a percent too. Is this because both equities and bonds go down with inflation scare? If so, how do we pick truly negatively correlated assets in an inflationary environment? I thought I was getting into this stuff, but I find myself confused. That was weird, wild stuff.

Mostly Voices [1:42]

Well, don't be too confused.

Mostly Uncle Frank [1:46]

The truth is, and I think we've talked about this before, that in the short term, The data can be very noisy. And what that means is you can have things that are generally uncorrelated over long periods of time be correlated over short periods of time. And that can go on for a day or a week or some months. And when you have a day like what happened on May 12th, you basically saw that people were just out there selling and nobody was buying yet. So what usually happens is not people don't sell and buy on the same day. Oftentimes what you see is there's just selling on a particular day and then people reorient their cells and buy other things on other days. So this tends to work out over time. Now as to inflation, well, it's kind of looking at the aura around the ball. See the movement of energy around the outside of the ball. In inflationary environments, what you'll see is Some of the stocks go down along with treasury bonds, but then other stocks and other things will actually go up because they do better in inflationary environments. And those things include small cap value stocks and commodities and REITs and gold in the circumstance where inflation is outstripping growth. And so if you took a look at March 13th, the next day you saw small cap value stocks were up 2.6%, commodities were up 2.0%, rates were up 1.1%. And so some of that stuff is reflecting people looking at what they want to hold in the environment that they are predicting and then going off and buying that after they had sold some other things. What tends not to do as well in inflationary environments are your large cap growth stocks in addition to bonds. But it's curious to see whether we're really having the kind of inflation that is talked about ad nauseam in the news these days because bonds are actually up in value. The interest rates have fallen since they peaked at the end of March and they are up in value since March 12th.

Mostly Voices [4:08]

A crystal ball can help you. It can guide you.

Mostly Uncle Frank [4:13]

But it is very common for stocks or bonds to remain in kind of ranges for months on end and then make some kind of a move after that. And they don't always do it in accordance with their long-term correlations. Now you can also use the ball to connect to the spirit world. So the best advice is probably not to look at it too much and look at it once a year would be probably the best advice, although most people are not going to be able to do that. And it's through the candle that you will see the images into the crystal. I think what may be helpful over time, if you go back and look at the historicals, if you go to portfolio charts in particular and put in whatever asset class that you're interested in is 100% of a portfolio. You can look at the table that is set out with all these little boxes and it's showing the returns over all years for the past 50 years. And it will give you a better sense as to how these things fluctuate over time and how they can be correlated for short periods of time but then be uncorrelated for longer periods of time, which plays into the overall correlation. Matrix. This is the one that I tend to use more often. So you're not confused. Don't feel bad. And I think you already see things to be sort of working themselves out. All right, next email is from Nick. And Nick writes, hi Frank, I'm interested in your thoughts on the following conversation between Big Earn and any reader in his work on the sequence of return risk. The attached screenshots were taken from the comments section of Earn's article on Is it Crazy to Hold 100% Equities all the Way Up to Retirement? I greatly appreciate and respect the work of both you and Big Earns. And actually, I feel these conflicting opinions are in need of resolution. Can you help shed some light on this issue? Nick, I did look at the screenshots. I'm not sure that we do have conflicting opinions, but Let's take a look at some of them and I'm just going to summarize what's on them because there were like seven of them and I don't want to try and read all through them. But anyway, there was a listener, Daniel, who was proposing a portfolio that looks a lot like the All Seasons portfolio that is one of our sample portfolios. And Daniel's portfolio in this was 15% US stock market, 15% small cap value, so just 30% in stocks, and then it has 55% in treasury bonds, which are divided into 20% long-term treasury and 35% short-term treasury and 15% in gold. So that's very similar to the All Seasons portfolio that it's one of our sample portfolios. And as I've said many times in talking about that, I've thought that that portfolio is too conservative with only 30% in stocks in it. that really for most retirees are going to be wanting a more stock driven portfolio. So having between 40 and 60% is probably a better metric to really go by. But Daniel was very interested in this portfolio because he had run apparently some kind of back test. It looked like he probably ran in a portfolio visualizer because he wrote since 1978 the compound annual growth rate is 9.17% and the worst year is -2.84% and he asks, what do you think? That is a limitation of Portfolio Visualizer in that a lot of the data goes back to 1978 because it does not capture what happened before that in the earlier 70s. If you take this same portfolio and go over to Portfolio Charts, which goes back to 1970, you'll see the real compounded annual growth rate is really only 5.4% and there is a maximum drawdown on this portfolio of 10% over the past 50 years. So it's not as nice as you would have liked to see if you just went back to 1978 on it. I'll improve on your method. So let's go to what Big Earn writes about this. There's some back and forth about it. And here's this bottom line. He wrote, this can work for short retirements up to 30 years, and when you're happy with depleting your assets, you only need a bit over 1% annual real returns to sustain a 4% safe withdrawal rate. For longer horizons, your allocation doesn't have enough expected return. Apply today's expected real returns of 3% in equities, 1% on gold, 0% in bonds all after inflation, and this portfolio returns Just over 1%, I guess that's over inflation over the next 10 years. And so basically what he's saying is what I've said before about this kind of portfolio with only 30% stocks in it, that it's a little bit too conservative for most people, I would think. That's why we're testing it out and you can see that it makes its 4% withdrawal rate, but doesn't make much more, at least so far as we've tested it. So I think we're in agreement there. Where we are in disagreement, I think, is the use of these expected real returns, which are averages for the future. And this is a really an academic discussion that we're talking about here.

Mostly Voices [9:49]

Now, the crystal ball has been used since ancient times. It's used for scrying, healing, and meditation.

Mostly Uncle Frank [9:54]

And what it gets at is the difference between A model that is based on fractals, as I recommend, and one that is based on Gaussian distributions where you care about the averages. In a fractal model, the averages are not very relevant to anything. And I'll give you an example of a thinking about the difference between these two things that hopefully will make it more clear. I grew up in Iowa, and Iowa, the average temperature in Iowa over the course of a year is about 50 degrees. But that doesn't tell you anything about what the weather is going to be like on any particular day, because the weather there is extremely variable. You can have days where you are at minus 20 degrees Fahrenheit, You can have days where it's 100 degrees Fahrenheit. It is rarely ever 50 degrees for very long in Iowa. And what that tells you is you don't really care about what the average is, whether it's stock market returns or other returns. What you care about is what kind of weather are you having? And then how will your assets or your clothing function during that weather because certain clothing is better for certain weather and certain asset classes are better in certain environments in terms of the stock market or financial markets, I should say. So if you're looking at what the weather is in macro finance, it's defined by two things. It's defined by the rate of change in growth, and then it's also defined by the rate of change in inflation. So you can have them both going up at the same time, both going down at the same time, or one can be going up and the other one's going down. And if you plot all those things out, and this was going back to the original work by Ray Dalio, which has been followed up by many others, you'll find that things perform well when there's both growth and inflation, as we've seen in very recent times with the reflation from coming out of COVID Then you have things like small cap value doing well and commodities doing well and bonds are not doing well. When you look at the opposite of that with both things going down, then the long-term treasuries are doing really well and pretty much nothing else is doing well. Various stocks perform differently in various markets. Large cap growth stocks tend to perform well in low interest rate environments or slowing interest rate environments that are also characterized by higher growth, then you have the environment that is called stagflation, where you have increasing inflation but decreasing growth, and that ends up being a good environment for gold actually, and a few other things. So if you think about this in terms of that characteristic that we are going to have different macro finance weather patterns in the future. Unlike the real weather, we can't forecast those like we can guess on the seasons. We can guess that it's going to be colder in the winter and guess that it's going to be warmer in the summer in Iowa, but we don't have that metric or that information to go by with financial markets. You can have any kind of weather in the financial markets at any particular time, and it's really not predictable. So I tend to view these attempts to predict the future averages of things, whether it's based on CAPE ratios or other metrics, as simply crystal balls that are based on Gaussian ideas.

Mostly Voices [13:56]

As you can see, I've got several here. A really big one here, which is huge. This is the one that I tend to use more often. I have a calcite ball and I have a black obsidian one here. Those are interesting metrics.

Mostly Uncle Frank [14:15]

They're interesting to look at the past. I don't know that they have that much predictive power for the future and at least nobody's been able to use them very successfully. successfully in trading investments. So I would put them aside and just think about, well, what if we just don't know? Let's have this don't know portfolio that will be sufficient in all kinds of weather, regardless of what comes up in the future. Yes! Because you're never going to have those averages come out in any particular year. It would be very odd if they did. you're either going to get much higher performances in some asset classes and lower ones in others, or vice versa. If you want to hear more about this and the general critique of trying to use averages to predict things, the most recent Rational Reminder podcast that I actually just listened to today, it's podcast number 51. This is Ben Felix's podcast. He's got a professor named Brad Cornell on. there that is written a number of things that are critical of the idea that you have stable means that you can use to predict the future, whether it's cape ratios or anything else. Because once you don't have a stable mean, then there is no predictive power for that. I did not know that. And that is part of the fractal nature of markets and not the what you call the Gaussian nature of markets, Gaussian things with Gaussian mathematics. mathematics are inherently predictable. Things that are based on fractal mathematics are inherently unpredictable for the most part. Cool. But that's probably enough of a academic and mathematical frolicking detour. Fire!

Mostly Voices [16:08]

Fire! Fire! Fire!

Mostly Uncle Frank [16:12]

In the end, Biggert and I agree that that portfolio is probably a little bit too conservative for most people. Okay. All right, next email is from Don H, and Don H writes, Uncle Frank, letting his thoughts be known about Wealthfront, risk parity portfolio. Love it. Well, thank you for that. He's referring to episode 85, where I was a bit critical of that portfolio.

Mostly Voices [16:38]

Yeah, baby, yeah!

Mostly Uncle Frank [16:41]

But as we saw there, the proof is in the pudding, and that pudding was a little bit Rotten. Your mother was a hamster and your father smelt of elderberries. But I'm glad you enjoyed that episode.

Mostly Voices [16:54]

Don't be saucy with me, Bernaise. All right.

Mostly Uncle Frank [16:59]

Next one comes from Matt H. And Matt H actually writes two emails. First one is, Love the show. Please run through the 10 questions for iBonds. I think they might be a good replacement for short-term bonds, cash, and a portfolio. Emergency Fund or Intermediate Term Savings. Thank you. Well, we will be doing that next week. That is an interesting thing to use, and I tend to agree, although there are some limitations that you need to be aware of in using those. So they are of some utility, but probably some limited utility depending on the size of your portfolio overall. All right, his next message is, love the podcast. Thanks for all the education. I think you should add a risk parity portfolio for someone in the accumulation phase. I'd also appreciate your thoughts on the following accumulation portfolio of 25% each in VTI, UPRO, VIoV, and TMF. Thank you. All right, well, I'm not sure you really need a risk parity style portfolio in your accumulation phase. Although, I mean, we're doing some experiments with things like that using these leveraged funds because the way that hedge funds operate risk parity is typically to take a conservative portfolio and then lever it up. And now that we have ETFs that are leveraged, we can experiment with that. The problem with these leveraged funds, as I've mentioned before, is that they don't have a very long history. and at least the biggest ones seem to perform as advertised even over longer periods of time when they're only designed for short-term trading. So that's why we have our experimental portfolios. As for what you're looking at, I think the issue you have there is VTI and UPRO are essentially the same thing. So there's no point in having both of them in a portfolio. either have a little bit more UPRO, then get rid of the VTI is probably the best idea that you can have there. You might also look at the leveraged fund TNA, which is a small cap fund. And so that could balance out a large cap fund if you were experimenting with these sorts of things. I would also throw some gold in there. so what you might fiddle around with is something that's UPRO, TNA, TMF, and GLD. I don't trust the leveraged gold funds, at least the ones I've seen. If you want to look at some ideas for using these leveraged portfolios, go look at the Optimized Portfolios website. I will link to that again in the show notes. That has a lot of the kind of standard portfolios and then leveraged up using these leveraged funds. And so you can get an idea for what those look like in that website. So my feeling is, yes, it would be wonderful if we can use this in an accumulation phase and that it works for the future. I just don't think we have enough data with the current funds we have to say that this is definitely something to put all your eggs into that basket. What you might consider is taking a smaller basket that is your leveraged portfolio and then doing something more standard with most of your accumulation portfolio, just so you don't get caught in something unexpected in the future. I said consummate, Vase. Consummate.

Mostly Voices [20:39]

It happened once.

Mostly Uncle Frank [20:43]

All right, then our next two emails are from Andrew, who wrote Two emails about an hour and a half apart on May 16th. And the first one reads, most of my investments are at Vanguard, including a certain percentage in their small cap value fund, VBR, which I added after listening to Paul Merriman. I notice you choose VIOV. I recently heard a warning that Vanguard's small cap value isn't really very small cap. What should I compare it to? I back tested with Portfolio Visualizer and they all look pretty well correlated in similar funds. Keeping in mind that stocks are largely correlated in small cap value doubly so, is there anything to be concerned with here in a risk parity strategy? Well, just so you know what the difference in history of this is, it's just a matter of which index they are using. So VBR, which is the kind of original Vanguard small cap value fund, uses what it's called the CRSP small cap value index. Now, the more popular index is actually the other one, which is the S&P Small Cap 600 Value Index, and that is what VIoV is based on. I believe that Vanguard constructed VIoV because they were losing market share to others with funds like IJS that follow the other Small Cap Value Index, the S&P Small Cap 600 Value Index. So now Vanguard has two small cap value funds, one that follows one index and one that follows the other. If you go and look and analyze these indexes you will see that the S&P Small Cap 600 Value Index, which underlies the VIOV, is smaller and more valuey, if you will, than the VBR. which goes on the CRSPSCV index. Now, I don't know this for sure, but I believe when Paul Meriwether was constructing his portfolios, he wanted to use Vanguard funds and VBR was the only one available at the time, and so he's just kept that. These two funds are very well correlated. What's funny about it is VBR, I think, has in recent times outperformed VIOLV. at least like the past 10 years or so, or how long VIOV has been in existence, because larger companies have done better in this time period. But in theory, the VIOV should outperform VBR over time by some small percentage. I think it's useful to have both available, mostly because you can use that for tax loss harvesting. If you want to sell VIoV and just turn around and buy VBR, you're pretty much getting the same kind of thing or vice versa. You keep using the word. I don't think it means what you think it means. And since they're both available there at Vanguard, well, you could buy them in other places too, but it's just a convenience. So I don't think using one or the other is likely to affect your overall outcomes that much when you consider that we're talking about something that's going to be less than 20% of your portfolio in most circumstances. Okay. But that's the skinny on those. All right, your next email from Andrew says, what do you think of implementing a risk parity pie using M1 Finance? Partial shares are available, trading is free, and it seems like they do dynamic rebalancing the same way you manage your model portfolios only automatically. Can you give me any reasons why I shouldn't do this? No, not really. It sounds fine to me. I'm not familiar with the way exactly the way they do rebalancing. I would just make sure that they don't do it too often and that it doesn't cause you some tax headaches along the way. That's why I really like to do manual rebalancing simply because I can look at it, look at my tax situation, and then decide what to sell, what to buy, and whether I need to do any tax loss harvesting or tax gain harvesting as the case may be. And that can only really be done manually because it's based on the rest of your tax situation. I guess the real question for you is whether you really need this kind of portfolio right now, a risk parity style portfolio. But that depends on your personal time frame and your risk. I would think M1 would be a decent way to do that. All right, I think we have time for one more. Last off. And this last one today is from Keith. And Keith writes, Frank, I'm listening to all of your older episodes from the beginning and finding it very helpful. Three things that I've never considered keep coming up, namely long duration treasuries, gold and small cap value stocks. It is the last item I want to ask you about. How do you feel about the amount of GameStop GME and VIoV? I can't for the life of me imagine a definition of value that would include a company like GameStop. It is currently the number one holding in VIoV. Perhaps you could explain how VIoV's holdings are chosen and how GME fits their criteria. VBR for whatever reason does not have a large amount of GME in it? Is it a better way to get small cap value exposure? I'm also curious about the origin behind treating small cap value as a separate class. Thanks again for all your work on this, Keith. Okay, yeah, this is just an interesting issue with these meme stocks these days because the index for VIoV is created only once a year and it's adjusted every December. And so apparently last December when it was adjusted, I think GameStop was still a very low priced stock, and then it's grown a whole bunch with all of this speculation in it. Expect the unexpected. I would imagine that if it's still like that by next December, it's going to be falling out of this index, because when something gets too large, or too growthy, it's going to get kicked out of this small cap value index. I will link to the technical parameters that they use to adjust this index, but it's literally taking these stocks, shoving their parameters into a mathematical formula, and then coming up with the 600 that match the criteria the best. So in any given year, there's going to be a number of them that get kicked out when they get too large, or too growthy. And I just see what you're seeing is that these things can bubble up through the ranks, if you will. I'm sure GameStop was a tiny part of it before the current explosion.

Mostly Mary [27:49]

Fire and brimstone coming down from the sky.

Mostly Uncle Frank [27:53]

But what's also interesting about that is that you see how diversification really works that you can't predict which of these particularly these small cap value stocks is going to outperform in any given year, at least most mere mortals can't. But by holding the whole basket of them, when one of them does rise up and explode into prominence, you are getting the advantage of that. And then to the extent that it gets too big or too growth oriented to be in the index, you end up selling it at a high point. And that's just the way that index is made up, but it's got that kind of self-cleansing mechanism that most indexes have that are based on a formula. Cool. As to your other question, that's another academic question. The idea about focusing on small cap value as a separate class of interest is something that goes back to what is called the Fama French three-factor model, which is based on a paper written by Eugene Fama and Kenneth French and some analysis they did. The paper was published in 1992. Eugene Fama had won a Nobel Prize. I'm not sure he won it at that point in time. It was for earlier work. But anyway, what they discovered by doing a long series of data analysis is that over very long periods of time, small cap value seems to outperform the overall market. And so there are three factors in this model were size, value versus growth, and then the price of the shares. They expanded that later into what is known as the five factor model, and that is what you see people like Ben Felix employing into their portfolio constructions of equities. So this idea has a long academic history, or at least long now. What's interesting to me is how new it is actually in the great scheme of things that it wasn't known until 1992. We are really just getting around to 20 years later as DIY investors incorporating these things into our portfolios. I don't think that most financial advisors do a very good job at this. They pull things out of their formula base and throw them in there. But this has become an accepted way of approaching equity investments. What's also interesting to me though, is that in 1992, you had just experienced a period over the past 20 years where small cap value did outperform large cap growth by large margins, particularly that period between about 1975 and about 1987 was very good for small cap value. and very poor for most large cap growth stocks. But after 1992, and in particular the past 10 years that we've had here, it's been the growth stocks that have outperformed. What I think the academics would say is that 10 years is just not a long enough period of time that is basically just noise in terms of analyzing the stock market. That 20 years is kind of a minimum period of time for looking at anything. and then what you really want to be looking at is periods of about 50 years to be able to say anything about parameters that might be useful in choosing stocks. And I will put a couple links in the show notes about the Fama French three factor model and how VIoV or the S&P 600 index small cap value index is constructed and renewed every year. in December. But now I see our signal is beginning to fade. You can't handle the truth. I want you to thank you for all of the interesting emails and questions that we got. I think it really goes over a lot of good issues for contemplation and meditation. If you have comments or questions for me, please send them to frank@riskparityradio.com that email is Frank@riskparityradio.com or you can go to the website www.riskparityradio.com and put your message in the contact form and I'll get it that way. We will pick up again this weekend with our weekly portfolio reviews and since it's also the end of the month we'll be talking about end of the month distributions and we'll do Some more emails if we have time. We are just up to May 16th on those. Haven't finished all the ones from May 16th. So if you sent me an email after that, your message is still in the queue. No more flying solo. If you haven't done so, please go over to Apple Podcasts and leave a five star review because every little bit helps there to get the message out. You need somebody watching your back at all times. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Mary [33:07]

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.