Risk Parity – “It’s about balance!”

The Risk Parity approach to investment management is changing the way some of the largest pools of capital manage their money. Originally developed by Ray Dalio and his team at Bridgewater Associates back in the 1990’s, this approach attempts to build portfolios that can handle a variety of economic environments.

The beauty of the approach stems from its simplicity. The simplicity of the approach is driven by the theory that asset classes react in understandable ways based on the relationship between their cash flows and the economic environment. 

The theory behind the Risk Parity movement can be broken down into two main points:

  1. Changes in market prices are driven by economic surprises (or changes relative to the expectations that are already priced in)
  2. The impact of economic surprises can be minimized through a combination of asset classes that perform well in different environments

The critical element of the asset mix is that the assets produce cashflows that react differently to four potential environments:

  1. Rising Inflation
  2. Falling Inflation
  3. Rising Economic Growth
  4. Falling Economic Growth

If an economic surprise is simply an unexpected event, then the key to building insulated portfolios is to have the right combination of assets (or asset classes) that offset one another during unexpected events.

One of the challenges with this approach is the unknown unknowns (ie. the Black Swan). A more realistic approach will accept the fact that the future is unpredictable, and choose to invest for the long-run by investing in a combination of asset classes that produce positive returns over a full credit cycle.

While no individual asset (or asset class) will perform in every environment, the effectiveness of the strategy relies on two things:

  1. Each holding must contribute to a positive return in one of the four environments.
  2. Each holding must also generate a positive return over the full credit cycle

At it’s core, the Risk Parity approach is basically four separate portfolios that react independently to rising inflation, falling inflation, rising economic growth and falling economic growth:
 

Filling In The Boxes…..
It would be difficult for the average individual investor to match off the risk of the different environments with a couple of ETFs or mutual funds. But I am reminded of a comment from a former colleague who said “If it’s worth doing, it’s worth doing poorly!”

Considering that my friend was a form Naval officer, the comment seemed out of character, until I realized that he was essentially saying that some movement in the right direction is better than no movement at all.

So here are a few broad things to consider when thinking about tilting your portfolio to toward the Risk Parity approach:

The key is to have a rising star for each of the four scenarios and to have a combination of assets that collectively hit your target return.

As we close out the year, I want to wish you all a happy holiday season and a very Merry Christmas! I look forward to the opportunity to connect with you in 2020.

Jim
 

Isaiah 9:6 “For to us a child is born, to us a son is given, and the government will be on his shoulders. And he will be called Wonderful Counselor, Mighty God, Everlasting Father, Prince of Peace.  Of the greatness of his kingdom and peace, there will be no end.”