What is Risk Parity Investing?

What is Risk Parity Investing?

Risk parity investing is an investment strategy designed to achieve balance and smooth returns across economic environments.

Economic environments can be broadly categorized across two factors: economic growth and inflation. The four combinations of accelerating/decelerating economic growth and rising/falling inflation produce four major economic environments.

Below are four quadrants summarizing these major economic environments and historical examples of these environments.

Depending on the economic environment, certain asset classes tend to do well while others tend to perform poorly.

• Stocks tend to do well in periods of accelerating growth with tame inflation.
• Treasury bonds tend to do well when economic growth and inflation are both falling.
• Commodities and stocks tend to do well during economic and inflation growth.
• Gold, commodities, and trend-following strategies tend to do well when the economy contracts and inflation rises.

A risk parity investment strategy will seek balance across these four major economic environments. Balance means (1) exposure to each economic environment AND (2) scaling asset weights based on their risk or volatility.

More volatile investments, like stocks, gold, and commodities, will have lower relative weightings. Less volatile investments, like intermediate government bonds, will have higher relative weightings.

Why Risk Parity?

By balancing asset exposures across the major economic environments, risk parity investing strives to smooth returns and lessen drawdowns and volatility.

Ultimately, risk parity investing targets the highest returns for the risk (volatility) you are taking.

Traditional portfolios weighted heavily towards stocks and bonds have delivered excellent returns over the long run. But over shorter time horizons -- even decade-long horizons -- traditional portfolios have delivered sub-par returns with rollercoaster-like rides.

For example, for the over 50-year period from 1972 through 2022, the U.S. stock market gained 10.2% per year

Great long-run returns.

But also within that period…

• the U.S. stock market declined over 40% on three separate occasions,
• stocks took more than four years to recover from each 40% decline,
• the market declined by more than half during the 2008 financial crisis,
• and had a negative 10-year period.

_{A comparison of the U.S. Stock Market (blue) vs. a Risk Parity-Style Portfolio composed of 30% U.S. Stock Market, 55% U.S. Intermediate Term Treasury Bonds, and 15% Gold, rebalanced quarterly. The stock market has been subject to deep and lengthy drawdowns, far more severe than the economically diverse and balanced risk parity-style portfolio. Source: PortfolioVisualizer}

During that same time frame of 1972-2022, a simplified risk parity portfolio of 30% U.S. stocks, 55% Treasury bonds, and 15% gold would have returned 8.4%. A lower return than the U.S. stock market, but with significantly less volatility.

Within that period, the risk parity portfolio…

• did not decline more than 20%,
• had a worst single-year return of -12.6%,
• took less than two years to recover from the 2008 financial crisis (during which it only fell 13%),
• and never had a negative return over 3 years.

_{A comparison of rolling 5-year returns of the U.S. Stock Market (blue) vs. a Risk Parity-Style Portfolio composed of 30% U.S. Stock Market, 55% U.S. Intermediate Term Treasury Bonds, and 15% Gold, rebalanced quarterly. The stock market exhibits a far greater range of 5-years, from +27% per year to -6% per year. The risk parity portfolio exhibits 5-year returns ranging from +18% per year to +4% per year. Source: PortfolioVisualizer}

While the stock market delivered greater returns, it did so with significantly more risk and greater drawdowns. The risk parity portfolio produced a far smoother return profile and better returns per unit of risk.

What are the origins of Risk Parity Investing?

In the 1980s, financial advisor Harry Browne developed the “Permanent Portfolio.” The Permanent Portfolio allocated 25% each to assets expected to thrive in each of the four economic environments: 25% to stocks, 25% to bonds, 25% to gold, and 25% to cash.

Importantly, the Permanent Portfolio’s allocations were simplistic in that they did not account for the volatility of each portfolio component. Risk parity strategies seek to balance these risks.

In 1996, Ray Dalio’s Bridgewater Associates launched the “All Weather” fund using principles that would later become known as risk parity. Dalio was primarily concerned with how traditional portfolios are heavily skewed and reliant upon stock returns. Dalio strove to build a diversified portfolio that was risk-balanced across economic environments, with the goal of delivering strong and consistent returns.

However, it was not Dalio who initially used the term “risk parity.” Instead, it was Edward Qian, chief investment officer at PanAgora Asset Management, who published a whitepaper in 2005 entitled “Risk Parity Portfolios: Efficient Portfolio Management through True Diversification.”

Despite Qian’s coining of the term, the popularization of risk parity investing is widely credited to Ray Dalio.

How does Risk Parity differ from Traditional Stock/Bond Investing?

Risk Parity differs from traditional stock and bond portfolios primarily through (1) a focus on exposure to the four major economic environments and (2) scaling allocations based on risk (or volatility).

Exposure to Major Economic Environments

Traditional stock and bond portfolios are typically composed of stocks and investment-grade bonds (a mix of corporate bonds and government bonds). Often missing from these portfolios are assets that tend to perform well during inflation shocks: gold, commodities, other alternatives.

Although widely acknowledged as a risk to stock and bond portfolios, inflation had been largely dormant since the Stagflation Era of the 1970s... until 2022. So prior to 2022, a stock and bond portfolio had done fairly well in recent decades.

Risk parity portfolios will have a dedicated allocation to assets intended to perform well during inflationary shocks, thereby intending to smooth returns even through an inflationary environment.

Scaling Allocations Based on Risk

Where traditional allocations will often skew towards greater stock allocations, bonds will often make up a larger portion of risk parity portfolios.

Because stocks are so volatile, even a portfolio of 60% stocks and 40% bonds will largely be driven by what stocks are doing. (Historically, a 60/40 portfolio of stocks and bonds has been highly correlated (0.98) to the stock market and has had 95% of its risk from the 60% stock allocation.) To combat the volatility of stocks, risk parity portfolios will often hold a far greater relative allocation to bonds.

In addition to a greater weighting to bonds, risk parity portfolios will often only hold government bonds (not corporate bonds). This is because corporate bonds, even high-quality, investment-grade bonds, tend to move with stocks during times of crisis – when you most critically want bonds to be offsetting your stocks.

Below is a recent example of bond performance during a deflationary crisis. When the S&P 500 (yellow) fell over 30% from February to mid-march of 2020, corporate bonds (purple) fell over 15%. Corporate bonds did little to protect portfolios during this event and have acted similarly during previous recessions (Global financial crisis of 2008 and the Dotcom crash of the early 2000s).

Treasury bonds (blue) moved in the opposite direction and did offset the stock market crash. However the stock market still declined more than Treasury bonds increased, which is why risk parity portfolios will often hold more in bonds than traditional portfolios.

What are the risks to Risk Parity portfolios?

While risk parity portfolios have historically exhibited less volatility and less severe drawdowns compared to traditional “balanced” portfolios of stocks and bonds, risk parity portfolios are still subject to declines and periods of poor performance.

Correlations go to 1.0

Risk parity strategies are predicated on combining diverse assets that zig when others are zagging, like when Treasury bonds zigged while stocks zagged in March 2020. In the event of each of the portfolio components all going down simultaneously, risk parity strategies are not going to often much protection.

However, given the underlying structural exposure of these asset classes, this has been an extremely rare event. And even during those time periods, the magnitude of declines of a risk parity style portfolio has not been greater than many of the drawdowns experienced by traditional stock and bond portfolios.

Underperforming Traditional Portfolios

Perhaps a greater risk is a behavioral risk. During raging bull markets in stocks, risk parity portfolios are highly likely to underperform. Lagging these traditional portfolios can lead to discomfort and switching strategies (potentially at exactly the wrong time).

1990-1999

For example, during the 1990s the U.S. stock market gained over 17% per year without as much as a 20% drawdown. A risk parity portfolio would be very likely to underperform and leave investors questioning the strategy.

2000-2009

But from 2000 to 2009, U.S. stocks went nowhere for the full decade, registering a modest decline for the period. And stocks suffered two massive bear markets during the Dotcom Bubble, declining over 40% from 2000 to late 2002, and the global financial crisis, declining over 50% from 2007 to early 2009.

Government bonds, on the other hand, produced 6% annual returns with no more than a 5% drawdown from 2000 through 2009. And gold returned nearly 14% per year. Risk parity strategies looked pretty good.

2010-2019

Then the 2010s began, a period of historically benign inflation with only a few short-lived stock drawdowns. 2010 through 2019 was a period reminiscent of the 1990s, with the U.S. stock market returning 13% per year. Bonds and gold gained 2%-3% per year.

Investors prone to comparing themselves to the stock market are at risk of switching strategies at precisely the wrong moment.

Leverage Magnifies Returns

Although not inherent to all risk parity portfolios, some risk parity portfolios will use leverage to target higher returns. Traditional portfolios aim for higher returns by offloading bonds and concentrating in stocks. Risk parity portfolios may borrow to increase their risk exposure (and expected returns).

During periods where cash outperforms, leveraged risk parity portfolios will suffer. Fortunately, this is not an expected long-term risk, because assets are expected to outperform cash over time (or else why would investors put money anywhere but bank account?). However, there have been brief periods (i.e. 2022) where cash is the best-performing asset.

Final Thoughts

Portfolios dominated by stock risk are subject to extreme fluctuations (to the upside and downside) based on economic environment. Risk Parity portfolios strive to reduce these fluctuations and provide more consistent returns through a balanced portfolio exposed to all economic environments.

However, while risk parity-style portfolios have delivered better returns per risk historically, they have also underperformed more concentrated portfolios during equity bull markets.

The best investment portfolio is ultimately the one you can stick with. But if your goal is to achieve more consistent returns during your investment time horizon, an economically-balanced, risk parity-style portfolio may be worth exploration.

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