How the Four-Quadrant Model Simplifies Asset Allocation

https://youtu.be/P6n7aFYUkk4During their recent episode, Taylor, Carlisle, and Buck discussed How the Four-Quadrant Model Simplifies Asset Allocation, here’s an excerpt from the episode:

Tobias: The four quadrants, I want to learn a little bit more about that too. You don’t need to predict what area you’re in. You’re always keeping a pretty balanced. So, it’s not predictive at all. It’s sort of come what may.

Jake: Agnostic too.

Jason: Yeah. I know you guys appreciate this somewhat. It’s amazing to me that I get invited to speak at events, because I just feel like I’m the turd in the punch bowl, because [Jake chuckles] everybody goes on stage and talks about their hero trade, and I go up there and I’m like, “Look, I can’t predict the future. None of these guys can. It’s all make believe. None of us have crystal vols.” We’re totally– [crosstalk]

Tobias: [crosstalk] it’s a good story.

Jason: Yeah. But I fall for it every time. We were just talking about before we got on, like, our homie, Ian Cassel, I went to lunch with him the other day. He’s telling me about stocks. I’m falling in love with him.

Jake: Yeah. [laughs]

Jason: I’m an optimistic entrepreneur. I fell in love with every stock he told me about. [Tobias laughs] I don’t know how you guys do it. So, yeah, we’re non predictive. So, if you think about what was the difference between like Harry Browne’s four-quadrant model, which Dalio eventually copied but never gave Harry Browne credit and he just leveraged up the bond portion, is then they were trying to leverage risk parity to your variance, or what people called the unfortunate substitute variance with volatility. And so, that’s semi predictive based on variance and correlation is how you would lever the risk parity portfolio.

But I like that Harry Browne just gave them equal weight, because over the long enough time horizon, your returns to risk are going to end up being one over N given the long enough time horizon. That’s why I like to equal weight of that. And if you’ve done risk parity in 1930s, you would be done game over.

So, the idea though with our four-quadrant model is like Harry Browne used stocks for growth, bonds for disinflation or deflation, cash for recession and gold for inflation. And the idea was, he had a rebalancing bands of, if any of them got outside the 10%, then you rebalance. So, he was 25% each. They got up to 35% or down to 15%, then he’d rebalance, which worked out to about every 1.4 years since 1972. And it was just a very– [crosstalk]

Jake: That’s higher than I would have thought actually. Like, more often.

Jason: Really. Yeah. I don’t know. Yeah. What? Who knows? BME probably went years and then those volatility kicks out that yeah.

Jake: Yeah. They cluster together more.

Jason: Yeah. We shouldn’t be talking about averages as we all know, our Taleb, we can drown in a river to average of 2ft deep.

Jake: Right.

Jason: So, the idea with Harry Browne is like non predictive. You’re in the four global macro quadrants as they move around. So, to me, the idea is, if you were alive today and had the tools we have, instead of cash, we use long volatility and tail risk gives you much more like a convex cash position. And instead of just gold for inflation, we like to use commodity trend advisors that can allocate to much many more of those commodity markets than just gold. But the idea like you’re saying Toby, is the idea is we keep those four quadrants fixed. And so, I would prefer rebalancing bands in general, as our good friend, Corey Hoffstein’s written about rebalancing timing luck.

So, I’d either like rebalancing bands or to rebalance much more frequently, but given trading costs, etc., that’s difficult. And then, just because we offer our clients monthly liquidity, we end up rebalancing monthly. So, yeah, it’s non predictive. But any rebalancing frequency or idea of rebalancing is essentially– you could say it’s pseudo market timing. But what I think about is, when you truly have four-global macro quadrants and an idea of rebalancing too is implicitly going to be mean reversionary or implicitly short volatility, honestly.

And so, the idea is, over a long archive of time, those four-global macro quadrants as money flows around the world into different asset classes, should mean revert over time. So, you are making that implicit assumption that you have some form of mean reversion. But I would look at it more as force scale trading. Because when you are off, Jake and I were talking about behaviorally, what it forces me to do is to incrementally scale into positions as they’re going into drawdown and incrementally start selling my winners. So, I’m rebalancing from my winners to the losers. And by doing that monthly, it forces me to do that. I’m not choosing of saying, “Ooh, I don’t know bonds. I should lighten up here.” Because if I predict the future, it’s going to be much worse.

Tobias: Yeah, I like that approach.

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