• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Spotlight>The Risk-Parity Approach

Related Content

  1. Videos
  2. Articles
  1. Practical Strategies for Today's Bond Market

    The outlook for bonds is just as cloudy as ever, but Morningstar's Miriam Sjoblom and Marta Norton offer helpful tips for setting the right expectations and creating a game plan in today's challenging bond market.

  2. Top Picks From Morningstar's Strategists

    Morningstar investment experts Russ Kinnel, Matt Coffina, Josh Peters, and Sam Lee answer viewer questions about the current market and the best opportunities in stocks , funds, and ETFs today.

  3. Bogle: We Need to Fix the Bond Index

    The benchmark index doesn't reflect the true allocations of U.S. bond investors, and the industry needs to look again at corporate- bond index funds or rework the current index, says Vanguard founder Jack Bogle.

  4. Give Your Portfolio a Checkup

    Morningstar's Christine Benz shows you how to uncover portfolio strengths and weaknesses, determine the impact of market movements on your asset mix, and more.

The Risk-Parity Approach

A relatively new way to construct portfolios says many investors aren’t truly diversified.

Samuel Lee, 04/08/2013

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.

Samuel Lee is an ETF Analyst with Morningstar.
blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.