The Problem with the Traditional Approach to Asset Allocation
The traditional approach to asset allocation is to tolerate higher short term risk through a concentration of risk in equities in
order to generate higher longer-term returns. A conventional portfolio has over half of its dollars and roughly 90% of its risk in
equities. This approach has a serious flaw — if the source of short-term risk is a heavy concentration in a single type of asset,
this approach brings with it a significant risk of poor long-term returns that threaten the ability to meet future obligations. This
is because every asset is susceptible to poor performance that can last for a decade or more, caused by a sustained shift in
the economic environment in relation to what was discounted. These shifts occur with enough regularity that you are virtually
certain to experience them in your lifetime if you hold a concentrated portfolio. As a result, the long-term risk of holding a
portfolio that is concentrated in equities, or in any other asset for that matter, is too great for most investors. Unfortunately, it is a
form of risk that the world’s pension fund industry has universally taken, leading to today’s pervasive underfunded status.
This form of long-term risk is unnecessary. While a balanced portfolio will have short term risk, it will be neutralized to sustained
shifts in the economic environment. This means that short term risks will indeed wash out over time and allow an investor to
focus on achieving the higher long-term returns that they desire.
Principles of Achieving Risk Parity
To achieve a quality Risk Parity portfolio, an investor must balance multiple sources of return to achieve consistent performance
across future potential environments.
We accomplish this by employing two steps:
¼ First, we increase and decrease the risk levels of all asset classes so that they have similar expected returns and risks. This
provides us with a menu of return streams that have similar expected returns and risk but have different relationships with
future economic environments (i.e. are lowly correlated).
¼ Second, we select from the menu to balance assets against one another so that the portfolio doesn’t have any bias to
perform better or worse in any particular economic environment. We accomplish this environmental balance by holding
similar exposures to assets that do well when ( 1) inflation rises, ( 2) inflation falls, ( 3) growth rises, and ( 4) growth falls.
Balancing a portfolio to shifts in economic growth and inflation captures nearly all of the potential diversification available to a
strategic asset allocation mix, because these are the two conditions that are most significantly discounted in the pricing of asset
classes, and are therefore the primary drivers of variations in asset returns.
Implementing Risk Parity: Our Process in a Nut-Shell
You can see our process in action through a simple example. Imagine a world of two assets: stocks and bonds. As shown at
right, stocks and bonds held at the same level of risk had virtually identical returns over the past forty years. And yet, the
paths of returns regularly diverged because stocks and bonds respond differently to changes in the economic environment.
As a result of their environmental biases, when stocks performed poorly bonds generally performed well, and vice versa. Given
that they generated similar returns but at different times, it makes a lot more sense to hold both of them rather than pick just one.
Balancing the portfolio between stocks and bonds would have reduced the portfolio’s risk by 25% and improved its Sharpe ratio
by 50% in relation to concentrating risk in either asset.
The environmental biases of the returns of stocks and bonds derive from their structural pricing characteristics. Stocks give
you a claim on earnings that is worth more when the earnings and the economy are stronger. Bonds give you a fixed stream of
payments that are worth more when a central bank reduces short term interest rates or inflation falls in response to economic
weakness. Because variations in the returns of stocks and bonds are structurally connected to the nature of the economic
environment through their pricing structure, the nature of their diversification advantage can be understood and will be reliable
BALANCING STOCKS AGAINST BONDS
Cumulative Total Returns (ln)
US Gov't Bonds at Same Risk
US Gov’t Bonds
at Same Risk
The return of stocks and bonds differ most significantly when there is a shift in economic growth. The following table divides
their returns over the past
40 years into two types of periods, those when growth was strong and those when growth was weak.
You can see the offsetting structural biases of their returns. Stocks generated most of their positive performance when growth
was strong and bonds generated most of their positive performance when growth was weak, and vice versa.
STOCKS & BONDS BALANCE EACH OTHER BECAUSE THEY HAVE COMPLIMENTARY ENVIRONMENTAL EXPOSURES
Excess Returns over Cash
A rising (falling) inflation month is defined as a month in which the current rate of inflation is greater (lower) than the 12-month moving average rate of inflation. A rising (falling) growth month is defined as a month
in which the current rate of real GDP growth is greater (lower) than the 12-month moving average rate of real GDP growth. Excess returns represent the returns over a Bridgewater proxy for the US cash rate for the
corresponding time period.