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Unbalanced Portfolios and Inflation -- The Risk-Parity Approach

A relatively new approach to portfolio construction says many investors aren't truly diversified.

Samuel Lee, 08/08/2012

The future delights in humiliating seers. Five years ago, who predicted that the rich world would reprise the Great Depression? And yet here we are: The United States government can run annual deficits amounting to 9.0% of GDP, triple the monetary base to $2.6 trillion in a few years, and still issue 30-year bonds yielding 2.6%. The surprising frequency of the "unthinkable" happening suggests we are overly confident in our ability to see the future. The "risk-parity" approach to portfolio construction is a powerful way to combat this mistake. Pioneered by Bridgewater Associates, modern risk-parity portfolios adhere to a simple principle: balance exposures across all the major economic scenarios by volatility. The hope is that such a portfolio will perform well in all economic climates--and indeed risk-parity strategies have.

The strategy is gaining influential adherents, mainly among institutions, but hasn't caught on with individuals. Will this strategy work in the future? Could an individual investor apply it? I think the answer is, tentatively, yes to both questions. To understand why risk-parity works, we have to revisit a common fundamental misconception of portfolio construction.

The typical investor thinks of assets as being like indivisible elements, with distinct characteristics. In contrast, the risk-parity approach begins with the observation that asset classes can be described in much the same way atoms can be described as combinations of electrons, protons, and neutrons. The fundamental particles in the risk-parity view of the world are inflation and economic growth. This isn't a modern insight, but one that's been around academia for decades. The risk-parity application is relatively new, however.

Standard portfolio construction advice does not lead to risk-balanced portfolios. The typical 60% stock/40% bond portfolio's volatility is 90% determined by equities, which are reliant on declining inflation and economic growth. What happens when inflation ticks up or growth slows? Standard portfolios fail.

The Four Economic Configurations
Economies have four main configurations, characterized by combinations of rising/falling inflation and rising/falling economic growth. Changes in inflation and economic growth can explain the gross behavior of almost any asset class.

Naturally, in each phase of the business cycle, different assets are king. Stocks do best when the economy is growing and inflation is falling, coinciding with the recovery phase after a recession; bonds do best when the economy is tanking and inflation is falling, coinciding with the downward leg of a conventional recession. These are sensible relationships--stocks rise in anticipation of increased earnings growth, and bonds rise when inflation or interest rates fall. For the most part, it doesn't really matter what kind of stocks or bonds you own--whether they're growth/value or corporate/Treasuries--each asset class will largely obey its relationship to economic growth and inflation.

Samuel Lee is an ETF Analyst with Morningstar.

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