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ETF Specialist

Unbalanced Portfolios and Inflation -- The Risk-Parity Approach

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

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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.

Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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