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Interesting comment re age assessment. Had come to same conclusion, but additionally noted attitude towards other people as very similar to the Wall Street types whose hubris the entire nation is now paying for, big-time.
hubris noun the hubris among economists was shaken ARROGANCE, conceit, haughtiness, hauteur, pride, self-importance, egotism, pomposity, superciliousness, superiority; informal big-headedness, cockiness.
I would recommend that your friend's first priority should be to do whatever it takes to convince himself that "capital preservation and appreciation" are NOT the goals he should set if he wants to satisfy his needs/wants...
If he were planning to spontaneously blow it all in one shot on a small yacht (let's say to impress some gold-digger he met unexpectedly) at some point then capital preservation and appreciation would be a worthy goal, but given the circumstances you described what his goal should be is a stream of regular income that can be derived from some combination of dividends and capital gains...and towards this end I agree with the perspective of David Swensen that the safety of an investment portfolio used in this way is determined by the stability of the dividends (and that doesn't mean past dividends or dividend yield as naively conceived of by some investors, but the likelihood of stable dividends being paid in the future) and the risk, by and large, determined by the amount of capital gains you intend to siphon from the pockets of the greater fools who may or may not materialize to take the other side of your trades.
So what one ideally wants to do in this situation is establish a safe floor of dividend income (which could include maturing bond principal) to satisfy one's needs and then use the principal to finance various arbitrage strategies to siphon whatever money might be left on the table by the greater fools, should they dare show up to play. There are many ways to employ arbitrage depending on the amount of time and skill you have at your disposal, but the simplest way to capture arbitrage profits I'm aware of that can be employed by an unsophisticated investor is, for a given level of future dividend income, to simply increase the volatility of one's portfolio as much as possible (which acts kind of like a bucket under a leaky roof because as volatility increases all arbitragers face more and more difficulty and their profits tend to spill over the edges and pool at the most volatile corners of the market...this is the source of the so called "risk premium" which really doesn't have much to do with risk at all).
So your question was what funds do I recommend your friend use to do this specifically? Well one way to implement it would be with one of Vanguard's Managed Payout funds...VPGFX, VPGDX, and VPDFX: Get the distributions direct deposited into his checking account, sign up for online mutual fund statements, shred/forget his password, and let the distributions grow (in case of VPGFX) or not (in case of VPDFX). This is not the only way to do it, but the key is realizing that if your need is a stream of income then your goal should be to grow a stream of income, not shoot yourself in the foot by fretting over irrelevant capital fluctuations.
I noticed that 10-20% of all three funds you reccommend are invested in Vanguard's Market Neutral Fund which I think gets back to the value of risk parity mentioned in this thread.
I have to admit it's hard to stay humble when being right enables you to retire before most people twice your age. But I'm not sure which is worse hubris or poverty because as the years go by all the old farts nagging me about my arrogance just seem to keep disappearing in the rear view mirror. Oh well, maybe the nation will be able to legislate me into being poor and dumb so they no longer have to pay the price of betting against me.
VPGFX only allocates 5% of its portfolio to Vanguard's Market Neutral Fund (VMNFX), which catch22 mentioned is not risk parity. And Vanguard's management fees are cheap enough that even if I expected VMNFX to experience guaranteed losses of 15% per year, at a mere 5% allocation, it'd still be less of a drag on returns than paying AQR to manage overall portfolio volatility with their "risk parity" approach.
Personally I, like David Swensen, think the best place to find market neutral income streams is away from the markets, but for investors that refuse to diversify away from marketable assets like stocks, bonds, and mutual funds something like VMNFX might be necessary as a tourniquet to slow the inevitable losses (just as I personally overweight international real estate stocks, not because I expect to benefit from outsized returns but because it's the only way I have to approximate the cash flows of that off-market business sector even if my returns are lower than direct investors). But I think these are minor concerns compared to having the correct mindset because an irrational aversion to volatility will surely penalize an investor far more in the long run than a slightly misallocated 10-20%.
The other thing is that there is some middle ground and just because very few investors have need to measure volatility for the purpose of liquidating their entire portfolio at a moment's notice it doesn't mean they all need to generate streams of income that extend infinitely into the future either...so it's not out of the question that something conceptually similar to "risk parity" couldn't find some limited use if the price were right, but I sincerely doubt the sophisticated wheel-spinning employed by shops like AQR will ever justify the cost.
Reply to @hank: Hi Hank. For right or wrong, I think of PRPFX as a static risk parity type fund of sorts and I had pretty good luck with that over the last 5 years. I mentioned some where along this thread I've been in the process of replacing PRPFX. So, I am looking at these new fangled choices.
As risk parity has caught on, some managers have tried to dress or fluff it up in dumb ways with silly fees. The essence has either been lost or they're simply not being transparent about it. Risk parity is easy to implement and as such should be cheap -- AQR has done a respectable job in this sense -- it's quite cost efficient, but others like Putnam are way off.
The basic premise of risk parity, or what its inventor refers to as the all weather approach, is that economies can generally be described to be in 4 states -- increasing or decreasing inflation and rising or declining growth. If you imagine a 2x2 matrix with growth on one axis and inflation on the other, you can group assets that do well in each quadrant representing the 4 possible combinations. If you do this by trying to size each of the positions in each quadrant based on similar volatility you are in effect trying to equalize the amount of volatility you're exposing yourself to at each stage in the business cycle. That's it. It's a framework for a more balanced approach.
The equalization of the volatility is not the focus; anyone that claims this to be the secret sauce, or some highly mathematical magic is kidding you. That's not what makes this approach beautiful -- it's the simplicity and the fact that it makes sense. It's fairly easy to look at the quarterly or annualized volatility of assets and size accordingly.
AQR having a moderate volatility fund targeting 10% volatility vs. the high volatility targeting 15% is just a matter of holding more of the same exposures in each quadrant. Since this is implemented with futures, it's quite easy to vary your volatility or leverage. If you own an e-mini S&P 500 contract in an account with $25K, your volatility will be higher than holding that same contract in an account with $100K -- it's the same return on equity, but 1/4 the return (or loss) on assets.
The main point I wanted to make here is that risk parity should not be compared to 'dynamic allocation', or 'tactical allocation', or any of that. The goal of risk parity to is neutralize manager risk -- it was designed around the basic premise that over long periods of time it's hard for managers to keep picking winners and outperforming the market. It's not actively managed; It's intended to be simple, transparent, and systematic framework.
It's also not new -- it's actually been around for 15+ years and has helped a number of pensions navigate the last decade in a much better position than the more traditional endowment-style portfolio.
Reply to @MikeM: i think what the author (BfB) meant is called LDI or 'liability driven investing'. if you know your future cash needs, you structure your portfolio to meet those. this is a different kind of investment strategy which best fits for insurance companies, mature and funded pension plans and retirees, among others. You don't care about the path, but about having the cash flows at a predetermined future time to meet a known liability. i don't think this kind of investing fits for all, but it does deserve some thought.
Reply to @BannedfromBogleheads: i, too, do not believe in 'risk parity'. i do believe however in diversified risk (even without the Fama reference). i think in anyone's portfolio construction, it is important to have some interest rate risk, some equity risk, some FX risk, and some credit risk. once one risk becomes overpriced (i.e. treasuries currently), it would be prudent to rebalance, in my opinion.
Reply to @VintageFreak: You're right, I am reaching. But look at the comparison since inception...against some other notable "Conservative Allocation" funds, like VWIAX, DODIX, FOCIX, PONDX, and (my fav) RNSIX:
Reply to @carvalho: "The goal of risk parity to is neutralize manager risk -- it was designed around the basic premise that over long periods of time it's hard for managers to keep picking winners and outperforming the market. It's not actively managed. It's intended to be simple, transparent, and systematic framework."
Comments
hubris
noun
the hubris among economists was shaken
ARROGANCE, conceit, haughtiness, hauteur, pride, self-importance, egotism, pomposity, superciliousness, superiority; informal big-headedness, cockiness.
Peace. (per rono)
I would recommend that your friend's first priority should be to do whatever it takes to convince himself that "capital preservation and appreciation" are NOT the goals he should set if he wants to satisfy his needs/wants...
If he were planning to spontaneously blow it all in one shot on a small yacht (let's say to impress some gold-digger he met unexpectedly) at some point then capital preservation and appreciation would be a worthy goal, but given the circumstances you described what his goal should be is a stream of regular income that can be derived from some combination of dividends and capital gains...and towards this end I agree with the perspective of David Swensen that the safety of an investment portfolio used in this way is determined by the stability of the dividends (and that doesn't mean past dividends or dividend yield as naively conceived of by some investors, but the likelihood of stable dividends being paid in the future) and the risk, by and large, determined by the amount of capital gains you intend to siphon from the pockets of the greater fools who may or may not materialize to take the other side of your trades.
So what one ideally wants to do in this situation is establish a safe floor of dividend income (which could include maturing bond principal) to satisfy one's needs and then use the principal to finance various arbitrage strategies to siphon whatever money might be left on the table by the greater fools, should they dare show up to play. There are many ways to employ arbitrage depending on the amount of time and skill you have at your disposal, but the simplest way to capture arbitrage profits I'm aware of that can be employed by an unsophisticated investor is, for a given level of future dividend income, to simply increase the volatility of one's portfolio as much as possible (which acts kind of like a bucket under a leaky roof because as volatility increases all arbitragers face more and more difficulty and their profits tend to spill over the edges and pool at the most volatile corners of the market...this is the source of the so called "risk premium" which really doesn't have much to do with risk at all).
So your question was what funds do I recommend your friend use to do this specifically? Well one way to implement it would be with one of Vanguard's Managed Payout funds...VPGFX, VPGDX, and VPDFX: Get the distributions direct deposited into his checking account, sign up for online mutual fund statements, shred/forget his password, and let the distributions grow (in case of VPGFX) or not (in case of VPDFX). This is not the only way to do it, but the key is realizing that if your need is a stream of income then your goal should be to grow a stream of income, not shoot yourself in the foot by fretting over irrelevant capital fluctuations.
I noticed that 10-20% of all three funds you reccommend are invested in Vanguard's Market Neutral Fund which I think gets back to the value of risk parity mentioned in this thread.
Thanks. Vanguard's overview, category fund for this fund, is "long-short".
Vanguard Market Neutral Fund
Take care,
Catch
I have to admit it's hard to stay humble when being right enables you to retire before most people twice your age. But I'm not sure which is worse hubris or poverty because as the years go by all the old farts nagging me about my arrogance just seem to keep disappearing in the rear view mirror. Oh well, maybe the nation will be able to legislate me into being poor and dumb so they no longer have to pay the price of betting against me.
VPGFX only allocates 5% of its portfolio to Vanguard's Market Neutral Fund (VMNFX), which catch22 mentioned is not risk parity. And Vanguard's management fees are cheap enough that even if I expected VMNFX to experience guaranteed losses of 15% per year, at a mere 5% allocation, it'd still be less of a drag on returns than paying AQR to manage overall portfolio volatility with their "risk parity" approach.
Personally I, like David Swensen, think the best place to find market neutral income streams is away from the markets, but for investors that refuse to diversify away from marketable assets like stocks, bonds, and mutual funds something like VMNFX might be necessary as a tourniquet to slow the inevitable losses (just as I personally overweight international real estate stocks, not because I expect to benefit from outsized returns but because it's the only way I have to approximate the cash flows of that off-market business sector even if my returns are lower than direct investors). But I think these are minor concerns compared to having the correct mindset because an irrational aversion to volatility will surely penalize an investor far more in the long run than a slightly misallocated 10-20%.
The other thing is that there is some middle ground and just because very few investors have need to measure volatility for the purpose of liquidating their entire portfolio at a moment's notice it doesn't mean they all need to generate streams of income that extend infinitely into the future either...so it's not out of the question that something conceptually similar to "risk parity" couldn't find some limited use if the price were right, but I sincerely doubt the sophisticated wheel-spinning employed by shops like AQR will ever justify the cost.
Take care.
As risk parity has caught on, some managers have tried to dress or fluff it up in dumb ways with silly fees. The essence has either been lost or they're simply not being transparent about it. Risk parity is easy to implement and as such should be cheap -- AQR has done a respectable job in this sense -- it's quite cost efficient, but others like Putnam are way off.
The basic premise of risk parity, or what its inventor refers to as the all weather approach, is that economies can generally be described to be in 4 states -- increasing or decreasing inflation and rising or declining growth. If you imagine a 2x2 matrix with growth on one axis and inflation on the other, you can group assets that do well in each quadrant representing the 4 possible combinations. If you do this by trying to size each of the positions in each quadrant based on similar volatility you are in effect trying to equalize the amount of volatility you're exposing yourself to at each stage in the business cycle. That's it. It's a framework for a more balanced approach.
The equalization of the volatility is not the focus; anyone that claims this to be the secret sauce, or some highly mathematical magic is kidding you. That's not what makes this approach beautiful -- it's the simplicity and the fact that it makes sense. It's fairly easy to look at the quarterly or annualized volatility of assets and size accordingly.
AQR having a moderate volatility fund targeting 10% volatility vs. the high volatility targeting 15% is just a matter of holding more of the same exposures in each quadrant. Since this is implemented with futures, it's quite easy to vary your volatility or leverage. If you own an e-mini S&P 500 contract in an account with $25K, your volatility will be higher than holding that same contract in an account with $100K -- it's the same return on equity, but 1/4 the return (or loss) on assets.
The main point I wanted to make here is that risk parity should not be compared to 'dynamic allocation', or 'tactical allocation', or any of that. The goal of risk parity to is neutralize manager risk -- it was designed around the basic premise that over long periods of time it's hard for managers to keep picking winners and outperforming the market. It's not actively managed; It's intended to be simple, transparent, and systematic framework.
It's also not new -- it's actually been around for 15+ years and has helped a number of pensions navigate the last decade in a much better position than the more traditional endowment-style portfolio.
Here is comparison of AQRIX with more traditionally allocated moderate funds:
Bottom-line: same high return with lower volatility.
That's the promise of RP. Time will tell I know, but right now, I like what the data says.
Fingers-crossed carvalho.