A relatively new way to construct portfolios says many investors aren’t truly diversified.
The future delights in humiliating seers.
In 2007, who would have predicted that the rich world would reprise the Great Depression? And yet here we are: The U.S. government can run annual deficits amounting to 9% of GDP, triple the monetary base to $2.6 trillion in a few years, and still issue 30-year bonds yielding 3%.
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 portfolio 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 advisors and individuals. Will this strategy work in the future? Could a client 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. This isn’t a modern insight, but one that’s been around academia for decades. The risk-parity application is relatively new, however.
According to Bridgewater, the fundamental particles in the risk-parity view of the world are inflation and economic growth. A 2012 paper (“The Risk in Risk Parity: A Factor Based Analysis of Asset Based Risk Parity,” by Vineer Bhansali, Josh Davis, Graham Rennison, Jason Hsu and Feifei Li) confirmed this observation, finding global growth and global inflation could explain the majority of the behavior of a variety of asset classes.
Standard portfolio construction advice does not lead to risk-balanced portfolios.