60/40 Is Dead! Long Live 60/40!

The Wall Street Journal had an article about the standard 60/40 portfolio, that is 60% allocated to stocks and 40% allocated to fixed income. Last year, 60/40 "tanked" but this year it is doing better. 

I've been bagging on straight 60/40 for a long time. It is valid, no doubt about it, it is a valid strategy, but it has been a long time since 40% to fixed income was optimal. The way I've been approaching this has been to build the 40% differently, to not pile the 40% or 35% or 45% depending on the client, all into fixed income. The presence of lower yields, that yes kept going lower, turned bonds, as opposed to bills and some notes, into equity beta. Some called the lowest yields "return free risk."

My experience is that the typical retired person/couple expects growth in exchange for some volatility from the equity portion of their portfolio, they don't want it from their fixed income sleeve. Fixed income holdings with equity beta stand to be far less effective at helping manage equity volatility with 2022 being a text book example that we'll study for the rest of our careers. 

The framing of this has always been simple. When bond yields were at all time lows that means prices were at all time highs. Buying a ten year Treasury note or ETF that tracks the ten year when the yield on the note was under 1.00% was taking equity risk. That's the very simple reality. Really under 2.00% it was taking equity risk. But when you buy an equity or equity proxy, there is no zero bound to prevent that equity from going up further. Yeah, you might pick the wrong stock or the wrong time for that stock but there's no "law of physics" to prevent higher prices. If the ten year had gone negative that would have been even a worse trade. The above is why I've taken to referring to bonds as sources of unreliable volatility.

It made no sense to buy down at that low yield to manage equity volatility and 2022 showed it increased portfolio volatility.  

Yields were kind of low in the mid 2000's before the financial crisis which was part of the story for why I started to use liquid alternatives (that term didn't exist yet), bond substitutes and bond proxies. This evolved for me into leveraging down and using more reliably negatively correlated holdings. Here's an interesting chart.

 

One of those lines is a 100% allocation to Vanguard Balanced Index Fund (VBAIX) which is a proxy for a 60/40 portfolio. The other line is 80% to a broad based equity index ETF and 20% to ProShares Short S&P 500 (SH). Over ten years studied, the CAGRs nine basis points apart and the standard deviations are more meaningful 0.54% apart. 

They're essentially the same portfolio but the one with SH took no interest rate risk last year and outperformed VBAIX by 491 basis points. I don't have that portfolio for anyone and never would but it is instructive to create understanding for how substitutes can be used to capture certain effects while avoiding the one year/event that was a catastrophe. 

If the math is not clear on the 80/20 looking like 60% equities, the allocation is 80% plain vanilla equity and then subtract the 20% in the inverse fund which gets to a 60% net equity exposure.

Here's something else that is interesting. 

 

Each portfolio is just one fund. Both funds are 100% equities. The blue line is the same broad equity index fund as above and was down 19.47% in 2022 while the red line was up 0.71%. Not much yield from the red line but in terms of volatility, I think this is what many people hope for from their bonds. If you've been reading the blog for a while you might be able to guess that the red line is the Merger Fund (MERFX) which is a client and personal holding. 

MERFX, any merger arbitrage fund probably, is 100% equity but it is long short, the type of long short that seeks an absolute type of return. I've described this and few others as horizontal lines that hopefully tilt upward. That's not really an equity attribute. MERFX is 100% equity (for the nitpickers, there is cash) but it is not an equity proxy.

I'm not sure how much fixed income that has equity beta should be in a portfolio but I don't think it's a high number.

I have used SH in client accounts in the past and while there is no near term visibility for using it, I imagine in some future cycle I will.

Black Swans & Shorter MLB Games

In my day job email junk folder was an email with the subject asking if you were ready for the next black swan. Black swans are a fascinating topic and a lot of people do not understand what the term means. A list of the "10 likeliest black swans" is the type of headline you see every so often and of course they are not listing potential black swans, they are listing potential, kind of widely known risk factors. Black swans are events that are not reasonably predicted by many people. Was the pandemic a black swan? Some people had been calling for some sort of pandemic for a while, I don't know why anyone thought there might be a pandemic but it happened and seemed to surprise a lot of people. What about the supply chain disruption during the pandemic? Was that a black swan? Again, I don't know.

Most of us probably don't need to try to guess what sort of adverse event or calamity might come as opposed to generally protecting against that adverse event or calamity. Where the stock market is concerned, how much does it really matter what caused some sort of big decline so much as it happened and if you try to protect against such things, did your strategy of protection help at all? 

Russia invaded Ukraine. Markets had a slow, steep decline. The pandemic was declared and stocks crashed and snapped back pretty quickly. Do you even remember why stocks crashed in late 2018? Do you remember the Taper Tantrum or the drop that coincided with the last time we flirted with the debt ceiling? Those events all happened, black swans to you or not, and stocks had some sort of drop. There will be future events that result in some sort of drop, black swans to you or not, and these become more important as you get closer to retiring in terms of sequence of return risk. Sequence of return risk can be mitigated by raising cash ahead of time or using tools that should go up when stocks drop as ideas we've talked about before. The important thing though is not what causes stocks to drop but how you mitigate the consequence. We know that every so often stocks go down a lot a scare the hell out of people. That will repeat in the future I promise you that. I  have no insight on what might cause future declines, I don't think it matters. I could guess, maybe be right, probably be wrong but can be wrong and still effectively protect against something like sequence of return risk. I think that's important to understand. The why doesn't matter <repeated for emphasis>.

It is also important to be resilient in real life too. I write about having a Plan B and for a short time earlier this year I had to confront whether I might need to pursue or implement my Plan B. I talked about this yesterday. At the demographic level, people who are 50 or 60 face unexpected job loss all the time. My call with this probably wasn't that close but it could have been. The behavior was a black swan to me, I was Taleb's turkey (Black Swan reference) in terms of expecting anything but prepared against the unpredictable. My Plan B was about losing my income not isolating a specific event. There's a direct corollary to the example above with the stock market. You don't need to guess what might cause a large decline 15 months before you plan to retire, you just need to be prepared in case it happens.

Because I think it is related, I saw a Tweet from someone who doubted that the typical 401k saver would have enough for their retirement just from their 401k. Not that people can't accumulate enough but that in his opinion, just having a 401k and nothing else won't be sufficient. 

The idea that people in the demographic sense won't have enough for their retirement by only having a 401k and nothing else is not a black swan. Any individual though might have the impression they are on track at 45 or 55 or 60 or whatever and then get to their retirement and realize they don't have enough (maybe they are the turkey in Taleb's context) or maybe they are all set but then some sort of real black swan happens to them, something unforeseeable that ends up being very expensive to solve. 

Any retirement plan runs the risk of coming up short for any number of reasons. Behavioral reasons can be mitigated by adjusting to a proper asset allocation before there is some sort of calamity in the market and/or making sure you have enough set aside in cash to meet x number of months' of expected withdrawal needs where x=whatever number lets you sleep at night. On the behavioral front we should also include training yourself not to panic sell if there is a large decline. Repeated from above, I promise you there will be future declines in markets and one or two of them will be huge. But then, at some point, the market will go back up. That will repeat no matter what you do so you might as well accept that reality which should greatly reduce the odds of panic selling. You know a huge decline will come, you just don't know when, maybe not for many years but at some point because that is what markets do. 

We cannot reasonably predict when those declines will happen. Yes, over the course of an investing lifetime you might get a couple right but being reliably right is improbable. 

And for fun, what do you think about shorter baseball games? I think the average game has been shaved off by 26 or 27 minutes due to the pitch clock. I guess people wanted shorter games. I love baseball, there's no such thing to me as a game being too long. During the season I have a game on as kind of background noise while I do my various work routines. It's there like a quick Pomodoro Technique, I can take a break to pay attention to an at bat or look up when the play by play's voice escalates. I'm doing that today. After hiking early, I have the Blue Jays Angels on, watching with one eye after watching the Red Sox Tigers earlier and then maybe a little Padres Braves at 4. One game running into another as I do my thing is pretty enjoyable.

A Blogger Looks At 57

Earlier this week, I turned 57. I started this blogger looks at series when I was 40, then posted at 50 then 55 and decided last year that a lot can happen in year so I wrote one for 56 and plan to do this every year for the time being. And sure enough a lot happened over the last year.

Before starting to write today's post, I read the others and it was interesting to see writing about the same ideas all the way back to 2006 when I was 40. Same ideas mostly but they seem to have evolved which is interesting on a couple of levels. For example, I've always talked about health but that used to just be about exercise really other than saying "don't drink soda." That has evolved to talk frequently about diet. I did not understand how important diet was and I came to start learning about that six years ago. I was told I was prediabetic, found and started low carb that day and the results have been profound. I solved my own problem.

Last year mentioned a lot potentially happening in a year (above too) and that really was the case over the last 12 months. On April 18th, Joellyn and I hit the road for a 10 day road trip starting with a big hike near Amarillo, down to the national parks in southwest Texas and then southern New Mexico. We made it to Gallup, NM when I first got word of what became the Crooks Fire. It was tiny, we kept driving getting just short of Tucumcari, NM when I found out that the fire blew up and was a serious event. We turned around and drove back, 14 hours of driving all in that day. 

For anyone new, I am the fire chief where I live and we were about to become the center of the fire universe. This picture is taken on my property. 

This turned out to not be a life changing event. It could have been I suppose but either way, this was an ordeal. Walker was evacuated, we put in a lot of work doing structure protection/prep out ahead of the potential path it might go (if that sounds dangerous, it wasn't). A week and half after it started on a Friday I believe, it snowed and the danger went way way down.

In August we took a direct lightning strike on our internet satellite dish which fried most of the house.

We jerry rigged our electrical so that we could have power but the process of fixing our solar dragged on for a full three months and was very frustrating. We supposedly got caught up in the supply chain crunch trying to replace the inverter for our solar and had to write a pretty big check for that inverter not knowing if the insurance company would come through. Thankfully a few weeks later they did.

The final challenge since last April happened with my day job. One of the partners of the firm where I have been since 2004 was found to have done illegal trading and he was immediately terminated. The other partner also has a serious problem that could be described as collateral damage. It didn't take too long to realize that their problems were not my problems but the remaining non-partner advisors (including me) had to find a place to land which we did. We've signed the paperwork and are in the 9th inning of completing that process. There were a few days of "how serious is this" then a lot of work to complete the process which as I say is essentially done now. 

These three anecdotes all fall into different sorts of unpredictability, the type of unpredictability that call for resiliency and optionality which we talk about all the time here. I live in a place where wildfires happen. It's not like you can predict when one will happen but there is preparation that can be done in terms of mitigating your property to remove ground litter than can burn, some of our property is sparse without too much tree density but some spots not so much. I put in a lot of fireline around our property once it got going in case it actually made its way to our property which it did not. 

Has your house ever taken a direct lightning hit? You can't really prepare for that specific outcome, there are protective devices that can be added to your electrical but in researching those, we learned they work except for the times that they don't. Oops. Living below our means though would have allowed us to take the financial hit for that inverter if the insurance company hadn't come through.

Something bad happening at work is one we talk about all the time. I've known the guilty partner for almost 25 years. Anyone can make bad mistakes but that he'd do something illegal (in a civil sense) was a complete blindside. 

I've talked a lot about the need to figure ourselves out to make sure we are targeting the outcomes we actually want. The work episode helped me better understand how much value I place on simplicity. Years ago, maybe 2007, I said no to being a partner at my firm. The reasoning was very simple. The tasks of interacting with clients and navigating markets is fun for me (helping people and studying markets) versus the complexity of running an advisory shop, all the regulatory filings, compliance processes that have to be overseen and even mundane stuff like leases and utility bills doesn't sound fun to me at all. Those things are the antithesis of my idea of simplicity and what I want to do. Had I said yes back then and stayed with it, I have to assume that I too as a principle of the firm would have some sort problem along the lines of what the collaterally damaged.

My blogging evolved a lot over the last 12 months into a lot more of what I would call portfolio theory with the capital efficiency and return stacking stuff. There's a prudent way to do this and a way that I think will blow people up but a tie in to a long standing theme here is taking bits of process from various sources to create your own process. Capital efficiency and return stacking have been additive to my investing process but the influence has been incremental not transformative. Again, I think there will be people who use these ideas incorrectly and really damage themselves.

Your 50's are well past the age where things can start to go seriously wrong, health-wise. Our best chance for aging successfully is a couple of simple habits that we talk about al the time; dramatically reduce carbohydrate consumption and lift weights. Simple even if not easy. Lifting with the right intensity is a cardio workout but doing traditional cardio won't be efficient in building muscle mass. The body composition benefit of adding muscle is very important. I've been lifting forever and learned about the diet six years ago and am much healthier for it.

Being blunt about it, my wife and I eating essentially the same diet and both being very physically active are aging very slowly. Yes, some people will luck out on this front but as I have said, I've never wanted to bet that I would be one of them. Anything can happen to anyone at anytime regardless of what they do but when you take on good habits you are doing what you can to pursue the outcome that most people want which I assume is being able bodied for their entire life.   

For men (not sure about women), there is no reason that at 50 you can't be about as strong as you were when you were in your 20's. There's no reason you can't have essentially the same shape you had (assuming you were fit) in your 20's. We've talked countless times about the financial benefit of this and repeated for the 1000th time, many chronic maladies associated with middle age can potentially be reversed, you just have to make the changes. I get it, people come up with reasons why they "can't," I have people in my life who know they should make changes, sort of know what to do but don't do it. It's up to you to solve your own problem.

Over the last year, Walker Fire took a monumental step forward, we got a grant for Type 3 Wildfire Engine that will change the game for us on several levels. We just got it last week. We have most of the equipment but need to buy a little more. Here is a picture from the maiden voyage that our assistant chief and I took it on, and I filtered the hell out of the picture. 

I've talked many times about my Plan B for Incident Management work. A few years ago, I was on a path to try to be a logistics section chief but that has evolved into pursuing liaison officer. There are multiple tasks associated with this position including helping small departments like mine get through a threat from a large fire. I've gone through quite a few of those and so the chance to pay that back appeals to me and so I'm going to try to take an assignment this summer. The response from a couple of different Incident Management Teams to my doing this has been favorable so I am optimistic. I want to try it and I do think it is right to pay back all the help Walker Fire has received over the years. Note on the truck, graphics are due to be installed on April 13.  

Being able bodied to an old age, for my entire life is a high priority. I've been putting in the work for decades and so far, so good which maybe is one interesting aspect of this series of these blogger looks at posts. Thank you for reading this.