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This was a tough week for the markets as the long expected and healthy correction finally surfaced. Times like these can be a little nerve wracking is there are always now shortage of people to go on CNBC and claim that the sky is falling. Remember two things about that:
1. Nobody can predict the market
2. Sensationalism sells—nobody wants to interview someone who says the S&P is going to go up 1% this year, they want to hear from either doom and gloom or the market is poised for a massive gain people.
The bottom line is that corrections in strong uptrends are normal and they are healthy. It is fun to watch a market go up in a parabolic up move but those types of moves almost always retrace severely (Apple, Gold, Japan, etc). I would much rather see the market go up modestly then slightly retrace and then resume an upward climb. Of course, being tactical, if this correction turns into something more severe we will react accordingly.
We made some minor moves reducing exposure to equities a bit and adding some international developed stocks to our Opportunity Strategies.
The Glaring Flaw in Risk Parity
Was forwarded an interesting article from Bloomberg the other day about some of the struggles in risk parity strategies, particularly Bridgewater’s All Weather.
This highlights the one glaring flaw in this approach—you are using past returns, correlations, and volatility to set allocations. Interestingly, this is the same reason why Modern Portfolio Theory does not work.
This highlights that even the most sophisticated money managers can still be sucked into believing that what happened in the most recent past will continue.
To us risk parity can be improved in three ways:
1. Use maximum drawdown instead of standard deviation as a risk measure. Nothing is perfect but clients tend to view risk more as drawdowns from a high water mark than day to day and month to month volatility.
2. Use methodologies instead of asset classes. You can get a better idea of what to expect from a methodology, say momentum or counter trend, than you can from an asset class.
3. Using the above two methods can avoid having large fixed income exposure reducing or eliminating the need for leverage.
1. S&P 500
2. US Small Cap Stock
4. US Dividend Stocks