Risk Parity

Fundamentals of Market Investing by Adam J. McKee

The strategy advocated by Ray Dalio has become known as a “risk parity” strategy.  In this sense, the term parity is used to denote equality or balance.  The idea is not without its very vocal critics.  One major criticism is based on the idea that risk parity strategies don’t really look at returns, and returns are what we’re in the game for in the first place.  Many discussions of the return of the strategy are based on Mr. Dalio’s spectacular returns in his Bridgewater funds.  Those funds are much, much more sophisticated than the modified versions that retailers can mimic with ETFs and mutual funds, and there is no possibility that you can match the power of that firm.  Most academics agree that risk parity strategies are only superior in terms of absolute return when a high degree of leverage is used.  That means active, expert management and a lot more capital.

I do not dispute these claims.  I am convinced that the best way to make the bottom line of your portfolio grow over vast swaths of time is to buy the market while employing tilts.  I work with a young man who has just recently earned his Ph.D. and has no family and no mortgage as of yet.  He has a full career ahead of him and is not so far removed from graduate school that living on a steady diet of Ramen noodles and pizza scares him.  He can take all sorts of risk, and he can get early massive gains because of those risks.  His strategy is to buy the market.  I think he has made a good decision given his circumstances.

If you, like Mr. Buffet, regard the optimal period in which to hold a security as “forever,” then you need not worry about risk or risk parity.  I may be guilty of projecting, but I feel like the vast majority of my readers will be those who wish to retire in comfort and security.  These folks work too hard and too long to stomach the volatility of a 100% equity portfolio.  The psychology of it all suggests that we will break with our discipline and sell when things get bad, and then buy back into the euphoria.

There are also mathematical reasons where low-risk portfolios can perform better than riskier ones that are not composed of diverse asset classes.  When we talk about the magic of compounding in this book, and I’ve shown you examples, I’ve used a simple computer algorithm that does its calculations based on an annualized return specified as a percentage.  This calm, predictable process maximizes your real gains such that they match what you’d expect by summing up the gains for each year.  In volatile portfolios, the magic of compounding still works, but it does not work as well in volatile markets.  Remember, financial professionals view risk as market volatility.

Thus, “safe” portfolios are those with less risk, and thus less volatility.  The bottom line is that over many years, a low volatility portfolio will yield better returns than a higher volatility one given the same simple returns during the period.  An all-equity portfolio stands to beat this trick of volatility by brute force; in years where luck shines on your portfolio, and it delivers alpha, nothing else can compare to those outstanding returns.  That decision boils down to how much risk you can afford, and how much risk you can stomach.

The vast majority of us have no business in an undiversified equity portfolio when we reach our late forties.  As the critics of risk parity portfolio allocation strategies suggest, we cannot ignore return either.  As I have argued elsewhere, you must make a decent return for investing to have a point.  If you do not reach your financial goals, it is essentially useless to invest.  My thesis is that you can build a low volatility diversified portfolio that can come very close to the long-term returns of a portfolio consisting entirely of the S&P 500.  The reason that I think this is possible is because of the magic of compounding and how it performs in the safe harbor of a low volatility environment.  I do not mean that the volatility of individual securities is necessarily low, but the entire portfolio has low volatility.

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Last Updated: 6/25/2018

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