[Editor's Note: This is a guest post from Phillip Guerra, DO, a “Risk Parity Portfolio Manager” with PhysicianCapitalPartners.com. He practices anesthesiology full-time and is working on a CFA. While I don't agree with everything in this guest post (see my note at the end) I thought it was an important topic to cover on the blog. Phillip's firm applied to be a paid advertiser on the site but I turned it down as I'm not at this time sufficiently convinced of the merits of risk parity to wholeheartedly recommend it as an investing strategy to my readers. Thus, we have no financial relationship at this time. Since he mentions his own firm late in the post, he wanted this disclaimer attached to it: Past performance does not guarantee future returns. Any investment with Physician Capital Partners may lose value.]
Most investors would consider themselves well diversified with a portfolio of 20-30 stocks; the risk of any single stock is manageable at that level. Even the father of value investing, Ben Graham, said as much in his book, The Intelligent Investor. With all due respect to Ben Graham however, the problem with this kind of “diversification” is that the portfolio is exposed to pure, systematic, undiversifiable, market risk – aka “beta” – aka the sensitivity of a security to market volatility. For example, owning shares of Apple, Microsoft and Google doesn't really offer much diversification if they all fall in lockstep during a bear market or in a correction or recession. Stocks can be highly volatile, and while their long-term returns make them worthwhile investments, stocks just don't perform well in all economic environments such as during a recession when GDP is falling. Or when inflation is out of control. Or with a relentless deflationary period like Japan’s Lost Decade.
Issues with Concentration Risk
But there is another, hidden problem with this “diversification”, and that’s because stocks generally exhibit at least three times the volatility – aka risk – that bonds do. Historically, stocks have had a volatility of around 15% and bonds around 5%. So after knowing this important fact, what happens to your portfolio’s risk if you allocate 60% of your portfolio to stocks – as in a 60/40 portfolio – Since stocks are 3 times more volatile than bonds, your 60/40 portfolio very strongly exhibits what is known as “concentration risk”. In other words, the risk of your entire 60/40 portfolio is completely dominated by its equity allocation.
However, the concentration risk in this resulting “beta portfolio” leads to an inefficient boom/bust risk profile since the portfolio’s entire risk is skewed heavily towards the equity component, and it decreases the portfolio’s risk-adjusted returns as a result. Worse still is that it can very negatively affect an investor’s retirement funds – especially if an investor just happens to retire right before a recession, a deflationary period, a hyperinflationary period, or any economic environments in which stocks do not do well.
Phillip Guerra, DO
By now, most people realize that stocks as an asset class don’t work well 100% of the time and in all economic scenarios (such as the Great Recession or the 2000-2002 bear market.) So why then should you choose a risk-concentrated 60/40 “set it and forget it” passive index portfolio? Aside from pursuing low fees and the difficulty for active managers to beat the market – both of which are very valid reasons – the best answer in my opinion is that your willingness to take on concentration risk should depend on market valuations such stock market cap vs. GDP as well as prevailing interest rates and the risk-free rate. For example, if market valuations are cheap, then concentration risk is very acceptable, and I think Ben Graham would agree on this. On the other hand if market valuations are fair or high – well, even Ben Graham mentioned that a defensive investor should consider a 25% stock / 75% bond portfolio.
But the real-life answer is probably that you, your financial advisor, or your new “robo” adviser may not even realize that there are other ways that may actually be better suited for an investor’s risk tolerance – and/or they just don’t want to take the time to calculate it all out. Yet this “beta portfolio” and its associated “concentration risk” is what most financial advisers and robo-advisers keep recommending to all their clients time and again. The only thing that really varies is the percent allocation to stocks. In fact, there’s even an overly simplistic formula that’s commonly cited: 110 – Age = the percent allocation to stocks that you should have. This is concentration risk at its finest – at least until you’re like 98 years old.
Risk Parity As A Solution to Concentration Risk
Is there another way? Yes, there is. It's called risk parity, and it can be thought of as a cousin to traditional asset allocation. Its greatest advantage lies in its elegant mechanism for achieving true diversification while its greatest disadvantage is due to its difficulty in constantly monitoring risk and calculating the precise allocations such that the risks of every asset class in a portfolio are equal.
Risk parity means forcing yourself to focus on the portfolio’s overall risk – not the percent allocation to stocks as a function of your age, time horizon, or some 110-Age formula. Risk parity means risk-weighting a portfolio – which is not the same thing as a 60/40 aka a capital-weighted portfolio. Risk parity is really just a fancy way of saying “I don't want concentration risk in my portfolio anymore. I value looking for a different way of doing things even if it means going against robo and traditional advisers' investing dogma. I choose to have equal risk among the asset classes in my portfolio – and I want to include all the asset classes in my portfolio that represent all the various economic scenarios that can occur – so that the portfolio can at least have a chance at working in all economic environments.” Having equal risk leads to true diversification – not diversification from owning 1000's of stocks or 100's of multi-family apartment units.
Fig. 1. Traditional vs Risk Parity (simplified) portfolios in terms of their asset allocation percentage and its corresponding risk contribution.
Notice in Fig 1. that the Traditional portfolio is a 60/40 portfolio, but due to concentration risk (because stocks are at least 3x more volatile than bonds), the Traditional portfolio is not risk balanced because the risk contribution of the stock allocation dominates nearly the entire portfolio. On the other hand, the Risk Parity portfolio – in this implementation of it (there are many variations of risk parity!) – seems to have roughly 12% allocated to stocks. However as a result of very precise stock allocation with deft attention to an allocation’s corresponding volatility, the risk contributions of each asset class to the overall portfolio are equal resulting in a truly diversified portfolio – one that is more immune to market volatility and generally has a lower correlation to the market along with higher risk-adjusted returns. This maximize the free lunch that diversification provides.
Achieving Risk Parity
How do I get a portfolio’s individual asset class risks to parity? Any passive, “set-it-and-forget it” portfolio whether risk parity or traditional 60/40 – or their active (i.e. dynamic) equivalents including an active, tactical risk parity portfolio or an active, traditionally-managed globally diversified tactical asset allocation portfolio – should be prepared for the various economic regimes that throughout time consistently affect a portfolio regardless of the economic cycle. The result is a true, risk diversified portfolio that at least has a chance to succeed no matter what situation the economy is experiencing at the time. In addition, having the ability to backtest a portfolio – a retrospective observational study similar to a case-control study in medicine – can add confidence to a strategy’s robustness while always keeping in mind that past performance does not guarantee future results. Running portfolios live is like a clinical trail and adds further, stronger evidence for a successful application.
Fig 2. Designing a portfolio to succeed in the four, main economic risk scenarios irrespective of the economic cycle. A risk-unbalanced portfolio such as a passive 60/40, “beta” portfolio with concentration risk exposure tends to struggle in the red squares.
To arrive at parity for a portfolio’s individual asset class risks is beyond the scope of this article. That said, there are three general ways to do it, and the reader is encouraged to do further research on his/her own- the simple way, the complicated way, and hiring someone else to do it for you.
The Simple Way
The simple way: Although there are many ways to define and estimate risk, the easy way is just to use volatility.
This is called naïve risk parity, and the formula in a two-asset class portfolio is:
Wa = (1 / σa) / ((1 / σa) + (1 / σb))
where
- Wa = weight of asset class a
- σa = std. dev of returns of asset class a
- σb = std. dev of returns of asset class b
- Wb = 1 – Wa
Unfortunately to do the simple way, you’d have to have some way to measure volatility either historical or implied over some rolling period, and you’d have to do it for several asset classes – not just two – because you’d want a portfolio designed to have a chance for success during any part of the economic cycle noted in Fig 2 (except during the rare situation where all asset classes return less than the cash rate). This difficulty in risk parity’s monitoring and calculation is probably the one hurdle that puts risk parity out of reach for nearly everybody – and this is supposed to be the simple way.
The Complicated Way
The complicated way is exactly that – complicated. There are many different versions of risk parity with each firm’s secret sauce being a function of different asset class mixes, covariance estimation, and varying levels of granularity within each asset class. For example, hedge fund Bridgewater is said to trade in 120 different markets. Since Einstein said to make things as simple as possible — but no simpler — we should probably just skip going over the complicated way, and this is likely good enough advice for most people if it’s good enough for Einstein. For the more daring, you can find all kinds of optimization formulas on this topic after determining marginal risk contributions. Here’s a start.
Having a professional manager do it for you is probably most people’s best bet. However each manager has their own quirks, and these quirks may exclude many investors:
- Closed to new investors
- $5,000,000 minimums to avoid sales loads
- Poor, inefficient performance
- High fees
- Non-transparency
- Not liquid (as in a risk parity hedge fund)
If an investor can find a risk parity pro that makes no compromises and fits an investor’s goals in every aspect, that investor should look deeper to see if that manager is right for them.
Our firm which runs a factor-based risk parity version ran tests to see how the portfolio would have performed during the last rising rate environment around 2002-2005 – and results have been encouraging. I believe our results are more tilted towards success because our strategy is based on scholarly, evidenced-based investment principles including factor-based investing which, although unusual for a risk parity firm, is a well researched subject of study. For example, Fama and French won the Nobel Prize in Economics in 2013 – and both of them contributed greatly to our understanding of how factors explain a security’s performance. Both our active and passive long-only versions and our active long/short risk parity version are based on these factor tilts. The active versions of our risk parity portfolios help prevent holding asset classes that are performing poorly, which is one of the weaknesses in traditional risk parity portfolios.
Benefits of Risk Parity
What should I expect by adding a little risk parity to my current total portfolio? An investor should expect for a risk parity portfolio to zig when the markets zag. That is, an investor should not be surprised to underperform during a bull market. If the market is rising at 20% per year, risk parity isn't going to keep up with those kinds of returns. This is simply the nature of alternative assets with low correlation to the market. However, this is also the exact characteristic an investor wants to have when the markets are trading sideways or falling. The first rule of investing is not to lose money according to Buffet. His second rule is to see rule number 1. The worst yearly start since the Great Depression is seen in the first two weeks of January 2016. An example of how this kind of volatility is made more tolerable for an investor by strategically allocating a portion of capital to Physician Capital Partner’s Active, Factor-Based Risk Parity with 7% Volatility-Target which at the time of this writing (1.24.2016) decided that the best bet was to hold a huge allocation of Short Term Treasuries and a touch of real estate investment trusts based on the firm’s algorithms. Remember the first rule of investing – don’t lose money. A Long/Short version of the portfolio was recently started the first quarter of 2016 and based on preliminary evidence is up around 4.1%. Recall that the market is down about 8-10% at the time of this writing. [This post was submitted to me the last week of January-ed.]
Fig. 3. A real life example of using low-correlated assets to improve an investor’s overall risk-adjusted returns. This investor has approximately 10% of his capital invested in PCP’s Active, factor-based risk parity with 7% volatility target. (Note: Past performance is no guarantee of future results.)
All of None?
So, does risk parity replace a traditional asset allocation? Not necessarily. While I'm comfortable using risk parity as a replacement, I prefer to think of it as a complement to a traditional asset allocation. Putting as little as 10% of your total portfolio can make a meaningful reduction in your portfolio's volatility and measurable improvement in risk-adjusted returns.
Avoiding “Deworse-ification”
In traditional portfolios, an investor’s risk tolerance is adjusted for by, you guessed it, adjusting one’s allocation to stocks. So those investors with higher risk tolerances or longer time horizons are typically placed in portfolios with higher stock allocations. However, along with higher allocations to stocks comes the disadvantage of higher exposures to volatility, further portfolio inefficiency, and a boom/bust risk profile.
Risk parity portfolios on the other hand are inherently for the risk averse investor. The result of true diversification is “the free lunch” that puts a portfolio along the “efficient frontier.” In modern portfolio theory this means the investor is getting the highest amount of return for a given amount of risk. But true diversification and high portfolio efficiency also results in low volatility, low beta and low expected returns. Some people call this “deworse-ification”. [This term is also used slightly differently, and usually derisively toward index investors by active stock pickers and direct real estate investors since index fund investors own both the good and the bad stocks.-ed] What can be done about this for investors who have higher risk tolerances or a longer time until retirement?
Using Leverage
The answer is to leverage the entire risk parity portfolio up to the desired volatility of the investor. Since we are leveraging an efficient portfolio, all the expected characteristics – beta, volatility, expected returns – simply become a multiplier of the non-leveraged risk parity portfolio. So for example, if a non-leveraged risk parity portfolio has a volatility of 3.5% and an expected return of 4%, leveraging this efficient portfolio up to 2x notional value would result in about 7% volatility and about 8% expected return (the returns include 2x the dividend of the non-leveraged risk parity portfolio). “Gearing up” the portfolio 3x the non-leveraged version would tend to result in 3x the volatility and expected return and so on. In the past, a 60/40 portfolio has exhibited a volatility of around 10-11% and a 7% return. Typical leverage amounts in risk parity portfolios are 2-3.5X.
The disadvantage of leverage is that it can only be performed with brokers who offer low margin rates. In our experience, TD Ameritrade has very high margin rates rates resulting in negative returns. On the other hand, Interactive Brokers has extremely low margin rates – allowing an investor to gear up a portfolio profitably. The other disadvantage of using leverage is the increasing risk of a margin call the more one takes on leverage. But this is a risk that an investor with moderate or high risk tolerance can endure because of the nature of risk parity portfolios having lower betas and lower volatilities compared to a traditional portfolio. i.e. Risk parity portfolios offer a smoother ride with less drawdowns and volatility than traditional portfolios.
Yet another disadvantage is that most investors exhibit a knee-jerk response to the word leverage. This may be because they are completely unfamiliar with risk parity and just have a general understanding that leveraging a traditional portfolio would induce stomach-churning volatility. This type of anchoring reflects a misunderstanding of the difference between leveraging an efficient, risk parity portfolio versus what most investors are familiar with already, a traditional but volatile portfolio exhibiting concentration risk.
It should also be noted that as interest rates rise, less leverage is necessary since the dividends of the fixed income allocation of the portfolio tend to increase as well – and depending on your risk parity manager, this could mean more monthly and quarterly income with higher interest rates. This makes it a little strange to think that you'd actually want interest rates to increase slowly and within market expectations. [No surprise there, higher interest rates are good for bond investors in the long run, as long as they doesn't come with higher inflation-ed.]
Volatility Targeting
Volatility targeting is one huge benefit that risk parity investors can enjoy and should not be underestimated. It is a way of objectively describing and targeting an investor’s risk tolerance rather than the old-fashioned, subjective way of just saying, “low, moderate or high” risk tolerance and allocating to “25%, 50%, 75% stocks” – and then just accepting whatever volatility your traditional financial advisor and the market gives you. On the other hand, when volatility is targeted, an active risk parity portfolio along with the dynamic use of leverage, the results can be profound and something that can add to an individual investor’s peace of mind in the markets. And that peace of mind is something that simply cannot be bought – nor overemphasized.
[Editor's Note: Interesting concept, huh? There are a few downsides worth thinking about before committing to a strategy like this one.
# 1 This is a relatively new idea. While people have been talking about risk parity for quite a while, only a tiny percentage of investments have been invested in this sort of strategy, and we have precious little data about performance. I mean, take a look at Exhibit A- this is Dr. Guerra's first year managing money. 76-99% of their 26-50 clients are not high net worth individuals. The firm manages just $37 Million. Basically, this firm is just getting started. It may not even be here in 5 years. Now, Exhibit B is some mutual funds that have been using risk parity. The linked article notes six of these, the oldest of which started in 2009 and all of which have an expense ratio of over 1%. Now, I don't necessarily require a decades long track record from everything I invest in if everything else about it looks okay. But it is certainly a strike against this strategy in my book. In medicine, you are advised not to be the first nor the last to adopt a new treatment strategy. That applies to other areas of life too, such as investing. Perhaps I'm wrong, and everyone will be using a risk parity portfolio in 20 years. But if I had to bet on it, I would bet this is more of an investing fad that will fade over time.
#2 The expenses are not insignificant. The mutual funds noted have expense ratios averaging over 1%. Philip's firm also does not work for free. Once you start adding on expenses like that, the new strategy has to not only be better, but it has to be at least 1% better. The Cost Matters Hypothesis is basic math- the more you pay the less you keep.
#3 One nice thing about a “know-nothing”/Boglehead/Fixed asset allocation of low-cost index funds is that you don't have to run manager risk. With risk parity, as Dr. Guerra notes, it's probably too complex to do it on your own. So not only do you have to pay for a manager, but you've got to pick the winning one. If that's anything like picking a winning mutual fund manager, it's going to be a tough task. Especially when almost no one has even been doing this for a decade. How are you going to choose without becoming an expert yourself?
#4 Why should risk be equal among asset classes? I'm not even sold on the basic concept, that you should take just as much risk with the bonds in your portfolio as with the stocks. Some very smart people, such as Larry Swedroe and Bill Bernstein, are quite adamant about taking your risk on the equity side and keeping your bonds short-term and high-quality. While I do take some risk on the bond side (notably P2PL), I think there is a lot of wisdom there. People have been making portfolios using risky and riskless assets for decades and it has worked just fine.
#5 There is too much focus on “shallow risk.” Stock market volatility has been used to scare investors into all kinds of expensive active management schemes in the past. I'm much more concerned about the more long-term risks that can affect my portfolio, such as inflation, deflation, confiscation, and devastation. Perhaps most importantly, the risk of my money not growing fast enough to reach my goals. As Phil Demuth has said:
Even if risk tolerance existed and could be measured accurately, why would it be an important factor to consult when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest “safely” if that locks in running out of money when you are old.
#6 I am leary of leverage. I suspect that debt has caused more businesses, investment schemes, and families to fail over time than any other factor. This is a “knee-jerk” reaction for a reason. Since a risk parity portfolio is 80-90% bonds, and bonds have a lower expected return, the only way you are going to achieve returns high enough to reach the goals of most people is to heavily leverage the portfolio. What could possibly go wrong? Adding leverage introduces a new risk that an unlevered investor doesn't have to worry about at all. I'm not convinced that it is better to run the risk of leverage than equity risk.
#7 I'm not convinced that your goal should be a portfolio that does well in all market conditions. A number of investment schemes have been proposed to deal with the fact that economic situations change, such as the permanent portfolio (25% stocks, 25% long bonds, 25% cash, and 25% short bonds.) The problem with these schemes is that the long-term returns fall short of those available with a more conventional strategy. I don't need my portfolio to do well every year or even every decade. I need it to meet my goals over 30-60 years.]
What do you think? Do you have a risk parity portfolio? What do you like or dislike about it? Would you consider investing all or some of your portfolio in this sort of a strategy? Why or why not? Comment below!
This column had me feeling much the same as I do when I walk the busy streets of Europe –
“hold on to your wallet!”
The “simple” method involves complex math, and the complicated method is just too complex altogether, so please don’t worry your pretty little head about it, just hand over your dough and we’ll take care of things for you.
Bonds are notoriously called return-free risk. So this “brilliant” idea is to up the risk?” Uh, no thanks.
Any column that claims owning 20-30 individual stocks is “diversification is immediately suspect; it only got worse from there.
Thank you for not accepting this nonsense as an advertiser. It is helpful to see the song and dance these people put on to try to peddle their questionable products.
I agree with your #4 and #7 notes.
Reeks of an attempt to confuscate. Sounds like a middleman I have about as much need for as the local travel agent’s office.
Who wants to buy some indexed annuities!!!
As long as the public is dumbed down, they will invest foolishly
37 million is pennies;probably most from the principals and family
One more scheme
For those familiar with the television show, Shark Tank, you know that the sharks (venture capitalists) do not look favorably upon entrepreneurs who come into the “tank” with full-time jobs that can pull focus away from the startup company being pitched. These folks are often unsuccessful in closing a deal with the sharks.
Along those lines, if risk parity is so complicated that even the “simple” method is completely inaccessible to my brain, leading me to entrust a financial advisor with my money, I want someone who eats, drinks, breathes, and sleeps this stuff. I would be less than comfortable handing over a couple million dollars to a full-time anesthesiologist who is getting his financial credentials on the side.
That said, I still aim to be receptive to new ideas. As much as I enjoy and agree with much of what I read on sites like WCI and Bogleheads, a bunch of people all piling on and espousing the same dogma can make us closed off to new and intriguing concepts. So I’d be very interested in learning and understanding more about “risk parity.” The current post, however, left me feeling like I should just stop asking questions and write a check, rather than feeling like I’ve given informed consent.
Agree with most of the above comments. However, keep these articles coming…if nothing else they reinforce my Lemming Investment Plan of a handful of low cost index funds.
And FWIW, a quick look at Salient Risk Parity Fund vs SP500 for 1yr is -22% vs -1%. It gets worse if you look further.
Reminds of the personal capital call I got. How they can reduce my risk while keeping the returns same. They did equal weighting in all sectors instead of capital weight of the index. Forgot what the strategy is called. At the end he asked me what would it take for you to join us, I said maybe when I die, my wife may consider joining them
Its Kudos to Dr Guerra to even get 37 million in investment. Wonder if he makes more as financial adviser than as a anesthesiologist.
Luckily, it’s fairly easy to guesstimate how much financial advisors/portfolio managers make (revenue-wise, net is obviously more difficult). The website says fees start as low as 80 basis points, so assuming the most conservative fee basis and $37 million in AUM, the firm brings in roughly $300k just in AUM fees. Not much after paying for the lights and split between two people
>#7 I’m not convinced that your goal should be a portfolio that does well in all market conditions.
>A number of investment schemes have been proposed to deal with the fact that economic
>situations change, such as the permanent portfolio (25% stocks, 25% long bonds, 25% cash,
>and 25% short bonds.) The problem with these schemes is that the long-term returns fall
>short of those available with a more conventional strategy. I don’t need my portfolio to do
>well every year or even every decade. I need it to meet my goals over 30-60 years.]
To be fair, the original idea of the Permanent Portfolio was to have some portion of your assets segregated in a supposedly disaster-proof allocation of 25% growth stocks (for growth during good economic times), 25% long bonds (for income during recessionary times), 25% gold (to protect against inflationary or hyperinflationary depression), and 25% cash (to protect against a deflationary depression), with occasional rebalancing to keep the allocation correct. The remainder of your assets would be assigned to your Variable Portfolio which would be invested however you chose to. The Permanent Portfolio was designed to be more of an insurance policy than an investment strategy; having an untouchable Permanent Portfolio was supposed to allow you to feel safe enough to be able to take above-average risks with the variable portfolio that would be the ultimate source of most of your investment gains.
Risk parity of some naive type is not new, does not have to be expensive and is not that terribly difficult to implement for an individual. There is no requirement for daily rebalancing and the like, thats something a PM needs to do to fill his day and earn his pay.
This was not a well written article and didnt really do the subject justice. For an overview that is more clear, read Cliff Asness’ “Why not 100% stocks”, from 1996. It makes the basic concepts very clear and non foreboding. A 60/40 portfolio is hardly any less risky than a 100%
The reason you diversify away from risk is because although we are told over and over again you get paid more for it, it turns out that it isnt true. Treasuries end up giving you a return well above their risk which is essentially zero. Risk adjusted return is key here, getting some return for any extra risk taken, not that hard to understand.
What usually happens is people pick a rate of return they require, then build a portfolio that matches this which can usually only be accomplished by filling it with risky assets. Instead, this suggests choosing a portfolio on the efficient frontier you are comfortable with, and levering it up to a standard volatility until the return matches your goal.
Yes, leverage that thing everyone is afraid of. This is what produces the excess returns in all likelihood, many people cannot and most people will not use leverage, and this leverage aversion (another Asness paper) is likely a source of out performance. Theres no requirement to be leveraged to the hilt at all times of course, and you could have a plan for increasing or decreasing leverage according to preset parameters.
It is an extremely interesting and not nearly as complex as presented topic. Theres definitely no good reason to be taking any excess risk, especially if you dont get a return on it.
The other benefit to having an overall lower risk profile portfolio is higher more consistent sustainable withdrawal rates in retirement. Though I doubt anyone on this site will have such a volatile portfolio mix to really risk this anyway.
Former bond trader here. With a leveraged portfolio consisting of 80 to 90% bonds, what happens if the historical standard deviations that Dr. Guerra is expecting deviate significantly? He noted that stocks are three times more volatile than bonds. In an environment where long term Treasuries are around 3% and the real rate on TIPs is negative, what happens if you get strong growth with unexpectedly large inflation in a few years time? The last time we had rates like this was in the 1950s. Individual investors increasingly buy bonds exclusively through mutual fund wrappers. When they decide to exercise intraday liquidity in large numbers, what happens to the 5% volatility expectation? Your portfolio could experience significantly higher volatility than 60/40. Equal weighting different asset classes has more appeal to me than risk parity
This is an interesting time period as all assets are expensive, housing, stocks, bonds etc.. and correlations going to 1 is a risk, but on a longer term view it isnt likely to stay that way. The last time this occurred it only lasted a short time, so its likely best to decrease your leverage in such a scenario, thatd be the safe way to manage this very real risk.
re: TIPS. inflation has turned positive. 1.4% for 2015.
Very interesting, but it doesn’t make sense to me to use a complicated and expensive strategy like this just to smooth the ride. Generally speaking, anything you do to reduce volatility will reduce return. I love the “get a grip” quote from Phil Demuth. It’s true, you either have the discomfort of price volatility when you are young and have income from your job, or you have the discomfort of running out of money when you are old and no longer have a job.
“Generally speaking, anything you do to reduce volatility will reduce return.”
-this is the whole point behind risk adjusted returns, and means that this post did a terrible job of explaining risk parity. Which is to increase your risk adjusted return, and find a level of volatility you are comfortable with first, then get the return you need within that constraint.
I get that, but then you have to contend with the higher risk, cost and complexity of these risk parity funds and leverage. I’d rather not.
Its not that complex at the basic level. It can be exceedingly simple. Pick your volatility level, allocate accordingly, apply leverage only if you have a terrible overall return. Even moderate leverage can do wonders without presenting large risks, especially given the ways one can get synthetic leverage these days.
Also, I think the broader point is to assess your risk level and make certain its worth it, not that one need adopt a fancy version RP, those are mainly that way because if they showed how simple it was or made it obvious, you’d just self replicate it and they lose AUM. Which, is happening all over the place now thankfully.
I have a solid technical background, so the math makes sense to me, but I’d still never implement risk parity. Why?
Because we don’t really know if our measures of risk for each asset class are accurate at any given point in time. IMHO, using historical standard deviation to measure risk is similar to using past performance to predict future performance. It doesn’t work. There are too many exogenous factors that can instantly change the risk of an asset class.
This same argument could be used for investing in general, why bother? Almost everything we do, whether or not its required to say the past is not the future, is based on it most likely being very similar. If that wasnt true, our behaviors would be vastly different.
Personally think to each his/her own.
Unfortunately this anesthesiologist is preaching to the MOST conservative group of “investors” out there. Doctors don’t do new strategies; they follow the herd. Which here it means they are 99.999999% index funds put it and forget it crowd. So good luck converting anyone. Why would he advertise here? Even if WCI accepted he wont get hits. Waste of his firm’s money.
Not a bad strategy if DIY. Otherwise, see above. Zaphod’s comment makes the most sense.
On a meta level, I don’t understand point of these articles from the blog’s perspective. If there is no healthy discussion on it and 100% of posters are like “oh yea this sucks. So glad I am doing Vanguard” whats the point? keep proving boglehead is a superior way of doing things and everything else is “lolsux”? Also the main arguments against any such strategy is Oh 1% expense – too high. Well then this just proves conservative thinking, which is fine. Just be fine with 5% real return going forward (http://www.amazon.com/Stocks-Long-Run-Definitive-Investment/dp/0071800514). Indexers should STOP preaching 7-8% long term returns. Garbage.
To me that is a poor return on money. Don’t give me crap about you should be happy with that. I am not happy with that. If market doesn’t give me that then I will supplement my physician income with higher risk of personal small business, or real estate etc to achieve it. Dave Ramsey has a show talking about debt or whatever, but thats his business making millions – easily dwarfing his “Retirement account”. WCI – same thing, he blogs about 401K but this blog makes 5x his retirement return.
No risk, no reward. Infact passive investment over past few years has decreasing returns. We’ll go back to 20% stock market 10 year returns all of a sudden? Not likely. I am not saying dump money in hedge funds, but lets not make passive investment as the OMG THIS IS THE BEST THING EVA!
Doing index means you are 100% at the mercy of the market and you HAVE to save 20-25% and work 20-25 years to have a substantial nest egg.
Thank you for that book reference Zaphod. Will search for it.
You know what I would want? A contrarian article arguing against boglehead returns and inspiring physicians to start businesses (filling out sermo surveys is NOT that – sorry)
Well, that’s fine if you want to spend your time running a personal small business, or real estate, but if you want to spend your time with family etc., getting market returns with a 3 fund Boglehead portfolio will result in plenty of money for a great retirement, despite today’s high market valuations, with our high incomes. It’s not all about “he who dies with the most toys wins”.
Actually I don’t fully disagree with this whatelse fellow. Infact, read what Xeno wrote below.
Retrospective analysis are just that; correlation. Bias and confounding abounds. Unfortunately your assertion of “plenty of money” is subjective. Money growing at 1-2% in equities for 10 years (very possible) just prolongs your work years if you are risk averse or you change your lifestyle. Point is NO strategy is perfect.
The article doesn’t provide a silver bullet and I sort of agree with “whatelse?” that passive index investing isn’t THE answer either although it is the least headache inducing and easy to DIY.
Decent article. Respect to this anesthesiologist who is doing CFA while full time and is a data nerd
The strategy appears not that much better than passive investing though. Major points by Jim I agree with.
“Risk parity focuses on allocating risk to asset classes, these asset classes are the leveraged to the same risk level and cash allocated accordingly.”
The above from Dr. Guerra’s first link explains the strategy better than his essay here. They add cash proportionately to each of the asset classes in anticipation of difficult climates.
1) bonds in rising interest rate enviros
2) high yield bonds that could default
3) both stocks and bonds in inflationary periods
4) any time risk in global equities.
Then leverage the whole portfolio according to individual risk tolerance
As for my self, I hedge against these difficulties by 1) stay short and suck it up. 2) avoid the high yield bonds altogether, 3) skewing heavily toward stocks. Stocks have historically survived better in inflationary periods. 4) I just take the risk; and actually enjoy the volatility.
Adding cash is the secret sauce against any asset class devaluation. Unfortunately cash is a drag on higher returns in another time period.
He defines “risk” as volatility. I define risk as failure to meet my goals. Can I send my kids to college? Can I still retire on my target date? Can my husband still buy historic guns when he craves? Good . then we can tolerate volatility, if we are prepared in advance.
This group relies on their superior brain power to outsmart the market downturns. I might have believed that too, prior to Long Term Capital Management / 1998.
Volatility comes when it comes. A 50% draw down of your portfolio is no big deal in your first year as an attending, but a 50% draw down 1 year from or just after retirement can wipe out decades of gains and change your life. Shielding yourself from unnecessary risk is an important tactic, and I think we all understand at some point of accumulation that part of the strategy is preservation of a bare minimum amount. There are lots of ways to achieve this of course.
I dont know why you would “enjoy” volatility unless you are using it to pour more capital in or going long/short volatility at opportune time. If you end up with the same total return but higher volatility you dont gain anything in the end, and have a more predictable path.
Mostly agree.
1 year short of retirement is 30 years short of death. It’s just another year on the portfolio calendar. Agree, we must be emotionally prepared for, but so too are the next 29 years.
I enjoyed the 10% drawdowns X 2 last fall + Feb. because I got to “do something.”
Me too, but Im younger and am excited when those things happen. Its funny because you get a lot of people on this site when talking about accumulation of assets that pray for a draw down when its the subject, but then lament stocks have gone nowhere for 2 years on another. That is exactly what a younger person should want, steady prices, I cant believe I can buy stuff right now at 2014 prices. This is of course the opposite if you have been investing longer.
I like your definition of risk.
I actually wasn’t able to get through the entire article before my eyes glazed over. But, from the comments sounds like I’ll stick with the current plan.
Now, Exhibit B is some mutual funds that have been using risk parity. The linked article notes six of these, the oldest of which started in 2009 and all of which have an expense ratio of over 1%.
This list, though i am only familiar with one of the firms shows the whole point of RP. Taking the two for demonstration purpose:
Fund 1yr rtn std dev Correlation to S/P
AQR 12.5% 6.8% 41%
60/40 12.5% 6.8% 99%
They had the same return, same volatility, but the 60/40 even though 40% bonds, was still 99% correlated to the s/p, while RP achieved those same results without that. Granted this was just a snapshot, but its really the whole point, one need not have themselves overly exposed to risk to have decent returns.
Now, I dont think one needs a complex or expensive RP type fund to gain insight from this. One can look at the other table in that article and see even more heavy bond allocations dont kill your results like you would expect them too. The main takeaway should be an assessment that more risk always equals more return, it has not necessarily been true and people have paid for that. This is obvious since the actionable investing manner would be to invest in the highest volatility stocks available, which is a known return killer historical and leads to destruction of capital. IMO, this should just open your eyes and make you rethink your allocations or risk profiles, and maybe check if you’re getting the return you are taking the risk for. I know I relaxed my view on bonds in a portfolio after doing research on this subject, they have their place.
Just for fun, I looked at the returns of each of the Risk Parity funds (run by “professional” managers) that WCI links to in his response #1. This only goes back to mid 2013, the first time that all 6 were in existence.
Percentages are not annualized:
SRPFX: -29.57%
CRAAX: -4.41%
MMASX: -5.32%
ABRYX: -16.19%
PDRYX: -7.67%
Compare that to Vanguard’s Balanced Index Fund (VBINX), the gold standard for the 60/40 portfolio, which is up 15.84% over the same timeframe. I’ll pass on risk parity…
Why is that during a time that both bonds and stocks are up these risk parity funds have negative returns? I’d have thought the equities would lag the market but be positive and the leverage bonds also positive? Isn’t that the general idea?
Some of these funds use commodities as an asset class, and commodities have taken a beating for all of the period. While most of us might limit our commodity allocation to 0-5% of our portfolio, risk parity probably levered them up.
Also, most of us pay 10bp for our funds, while these funds charge about 120bp, and that adds up over time (note that the performance numbers above are not annualized).
I understand commodities as a class, but levering them up is crazy. They are super volatile, levering a volatile class will crush returns even if youre directionally correct. You can see examples of this in 3x levered ETFs in some of the more volatile commodities, the bullish and bearish etfs both end up with large losses on the year.
I read the whole article but I still have no clue how Dr. G is investing his clients money to achieve “risk parity.” Dr. G mentions long/short stock funds — is the entirety of his strategy. Long/short is a common strategy for hedge funds, though it doesn’t seem ideal for the average investor.
WCI mentioned the permanent portfolio, which I assumed was the focus of this article when I read the title, though the OP does not mention it. Is the OP trying to be his own hedge fund?
This is a bit of a comment on this post and a bit some of the comments on WCI’s last post about being a DIY financial planner, where commenters try to quantify the value of a financial planner and see whether it justifies the increased costs vs a target date fund, or whatever.
There are two huge systematic flaws in how people think about investing and asset allocation:
1. They decide they need $X/year in retirement, in inflation-adjusted dollars, so they need to save Y% of income/year and work for Z years, assuming their portfolio returns W%/year. Usually, the first few times folks run these numbers, the values for Y and Z are too high, so they arbitrarily decide they need to increase W, which to a first approximation means increase stock allocation or try riskier (or more leveraged) investments.
2. Everything we know about investment returns is from historical data (including things like small-cap and value tilt), but those of us who read the medical literature should if nothing else know how many promising things come from retrospective data that fail to pan out when tested prospectively. Bernstein says that we should not expect 10%+ stock market returns in the future, but perhaps should expect 4% in real returns from stocks and even less from bonds (clearly less than that in TIPS, which are already priced as a real return). Bernstein is way smarter than I am and knows a lot more about this than I do, but his rational expectations, are just his best educated guesses, nothing more. The highest quality data we have on stock market returns are a little more than a century old. We could have 9% annualized stock market returns over the next 50 years, or we could have -3% annualized stock market returns over the next 50 years. Who knows?
Conclusion that tries to avoid these errors:
I think that while it is helpful to think about what sort of financial means one wants to have when she retires, one cannot rigidly be driven by some sort of expectation of return and the variation in that return in an annualized basis. There are risks that simply are unknown and unknowable that won’t turn up in an sequence of returns Monte Carlo simulation. You may also get windfalls along the way that could not be expected in any sort of model.
My personal plan is to save 20% of my income into some investments that seem prudent, are somewhat diversified, and are low cost and plan to work for least a couple of decades. If I have amassed millions of dollars at some point, then I might reassess, but I don’t expect to have a 99% success rate based on a certain savings %, a certain portfolio return %, and a safe withdrawal rate of Q%. That’s just silly.
You want to be prudent and smart, but these portfolio acrobatics are just as spurious as trying to calculate the NNT for a medication to anything more precise than an order of magnitude (e.g. 10, 100,1,000, or 10,000). If my doctor told me that Lipitor has an NNT of 117.46 so therefore I should take it, I would have a lot less faith in her than if she told me that her best understanding of the available data suggests that taking Lipitor would provide me with more benefit than harm.
I agree with the unknown and unknowable comment and the general sentiment to be prudent and smart, save a bunch, and invest it in a reasonable way and adjust as you go.
“Fama and French won the Nobel Prize in Economics in 2013 – and both of them contributed greatly to our understanding of how factors explain a security’s performance”
Unfortunately they didn’t contribute greatly to his understanding of who won the Nobel Prize in 2013.
Why so critical? Fama was one of the winners in 2013.
https://en.wikipedia.org/wiki/List_of_Nobel_Memorial_Prize_laureates_in_Economics
I think it’s worth noting that this strategy (which i think Bill Gross is the main proponent of), comes at the heals of good risk-adjusted returns on bonds. Harder to sell leverage on something that has done poorly.
I do take issue with one of WCI’s lines though. That the goal of a portfolio shouldn’t be stable appreciation in all market conditions, but long term growth. This is true in accumulation, but not at all true in withdrawal. That’s why there is a 4% maximal withdrawal rate with projected 7% real returns. Now I’m not at all convinced that leveraged bonds are the best way to achieve stable growth. Maybe when I retire I’ll invest heavily into triple net leases or something. I have about 40 years to figure that out…
Matt, you can deal with this sequence of return risk by not selling stocks when they are down – sell bonds and if need be use cash instead.
This is akin to the martingale strategy in roulette of always doubling your bet as you lose.
you are:
A. Increasing the percentage of your portfolio that is stocks and are decreasing the percentage that is bonds.
B: essentially market timing
Now to be clear this is not necessarily a bad strategy. I’ve shifted from 75/25 bonds to 90/10 bonds post 2008. But it is riskier than simply rebalancing and I wouldn’t recommend it in retirement unless you have far more than you will need. It’s certainly not a great strategy if it ends up giving you or your spouse a panic attack even if you end up making money.
We should be more clear in that the Martingale strategy is a bad strategy and will lead to portfolio blow up. Shifting allocation percentages based on the cycle isnt necessarily so.
That is not sequence of return risk. Sequence of return risk is the market being down when you HAVE to withdrawal to live. It also occurs in the last 5-10 years of contributions. Anytime there is cash flow going on in your account you have sequence of return risk. Decreasing volatility makes this less of a risk as you can have more stable withdrawals.
You are correct that stable appreciation is better than volatile appreciation all else being equal, but that’s true in both accumulation and distribution. Actually to be accurate, you want your best returns late in accumulation and early in distribution. But if I had to choose a somewhat volatile annualized 8% versus a stable annualized 5%, I’ll take the 8% every time.
Yes. There are some great papers that demonstrate this effect. Two people with the exact same contributions, years working, and CAGR can end up with drastically differently portfolio values depending where in that time their returns came.
That should be obvious I guess, but when you see it on a chart its pretty impressive. Everyone likes to say that over time volatility evens out and its gets “safer” with time, but if you’re lucky enough to get a large account balance it gets riskier. Luckily so far, its mostly to the upside, but mathematically true.
Here are some follow-up performance results for physiciancapitalpartners.com returns for Q1 – the worst weekly market start in history. https://www.hvst.com/posts/61324-how-we-beat-hedge-funds-at-their-own-game-in-q1-2016.
In short, everyone should allocate capital to alternatives. For example, BNY Wealth Management is recommending a 16% allocation to Alternatives for a friend of mine who is in her 60’s.
Investors don’t have to allocate to risk parity nor our firm. But any alternative strategy chosen ought to be at least evidence-based like ours is – so it can have the best chance to help mitigate your overall portfolio’s volatility. We just signed up two family offices in April each with over $200MM in AUM; if we’re good enough for these pro investors, we’re probably good enough for a lot of physicians too.
I thought those reading this post would also enjoy this article: https://blogs.cfainstitute.org/investor/2016/05/05/does-the-buffett-bet-signal-the-end-of-active-management/
Interesting that a bunch of physicians with hundreds of thousands of dollars of student loans are so afraid of leverage. We leveraged 10 years of earning potential. I think it lies with the intellectual shortcut of debt = bad. Leveraging a portfolio is done to reduce risk not to increase risk.
The risk parity model I have seen most which was not well explained is using leverage to increase the return on your bonds. When your bonds have an increased yield for a proportionally smaller risk you can move more assets to equity positions and can have more of your portfolio for the historically higher performing equity assets. When stocks go down your bonds are suppose to carry your portfolio. Bonds act as an equity buffer. If you can “buy” that buffer for a lower percentage of your total portfolio and divert what would have been spent on bonds towards stock then you have maximized your downside protection for the lowest cost and have maximized your upside potential. This is accomplished through leverage.
The nice thing about an unleveraged company, portfolio, or family is it can wait out bad times for a long, long time. Hard to go bankrupt without debt. Whether that’s a good idea or not probably depends on how much upside you’re giving up.
Warren Buffett wrote:
Very true if the leverage increased the risk. If used wisely it decreases risk. It is counterintuitive and hard to get people to move past the debt = bad mantra. The rest of us will use leverage to both decrease volatility and risk and to optimize our gains for a given risk level. This is the so called efficient frontier of modern portfolio management.
If used incorrectly then it is terrible. When people that know nothing about investing use leverage it’s terrible. At that point it is gambling and doubling down.
Lots of smart people have thought up ways to have leverage reduce risk. Sometimes it worked, sometimes it didn’t. LTCM and the Boglehead markettimer’s examples come to mind. Worth a read if you’ve never seen it:
https://www.bogleheads.org/forum/viewtopic.php?t=5934
When you buy a house and put down 20%, you’re leveraged 5:1. Why do banks allow you to do this? B/c they know that the price movement of your house doesn’t not move much in a year – i.e. the monthly price returns have low volatility aka low risk aka “safe.” The problem of course is that your house doesn’t give you any income.
Recall that these days, it pays to be a borrower not a saver b/c rates a so low. Let me show you one reason why:
Why not construct a portfolio that has very low volatility, has a yield of about 2%, and each asset class is very carefully weighted such that if GDP and/or inflation move up, down, or mixed up/down, the portfolio will still over the long run ever so slowly march upward and increase in value?
This would be sorta like the house that you bought b/c both the price of the portfolio and the house move very slowly – except this portfolio earns you 2% dividends. Yet this portfolio only “moves” about 1/3rd as much as a 60/40 portfolio. It’s totally boring b/c it doesn’t move compared to a 60/40. It’s like watching paint dry.
But what if you leverage this slow-moving, carefully weighted portfolio 2x the original amount and using the same asset class weights? Now the portfolio “moves” about 2/3 as much as a 60/40 portfolio – except that this leveraged portfolio has:
1. It has 4% dividends.
2. Can ride out markets better when GDP and/or inflation go(es) up, down, or mixed (b/c we carefully weighted its asset classes)
3. Because it moves more, it’s not as boring as the original 1x portfolio that wasn’t leveraged.
So how much leverage do you need to use to get the original 1x slow-moving portfolio to move about as much as a 60/40? That’s right, about 3x. But in this “super-leveraged” portfolio that “moves” just like your “safe” traditional 60/40, “target-date” portfolio or “balanced mutual funds” that 99% of the world believes in (remember 2008?), you’re now getting a 6% yield – and this portfolio STILL rides out GDP and/or inflation better than 60/40 (b/c again you carefully weighted it’s asset classes from the beginning).
So what is the cost for this leverage? It depends on your broker and on the gross dollar amount that you’re borrowing. Like Coscto, if you buy in bulk, the price is cheaper on a per unit basis. The same is true with portfolio leverage. It can be as low as 0.62% or as “high” as 1.6% depending on the amount you borrow. That’s way better than a house mortgage btw and probably any other loan for that matter!
So the rational market participant realizes that it really DOES pay to be a borrower and not a saver these days – IF you what toure doing and know how fast/slow you asset “moves”.
That’s the gist of risk parity. If you have daily access to to your portfolios metrics and can do the math, you too can “gear” up or down – and completely to your liking – a portfolio’s volatility, beta, expected returns, CVaR, VaR, and drawdown too if you begin to manage the portfolio more actively vs passively.
The end result is really the ability to create “scalable beta” that now minimizes the need of determining intrinsic value and margin of safety a la Ben Graham. Having “scalable-beta” and having a mechanism for understanding and targeting volatility at the portdolio level seems like a much better idea to me than buying “smart-beta” or “low-volatility ETFs” – and overpaying for them b/c everyone is piling into these ETFs at all once these days.
Put simply, there other ways to skin a cat than blindly following traditional dogma and not further questioning the reasons, the science, the mechanisms behind your choices – which to me seems unscientific and un-physician-like b/c there would be minimal progress and improvement.
You can find out more at: PCPpresentation.com
The Vanguard 20/20 portfolio was ~ 60/40 in 2008. It lost 27.4% that year. Peak to trough share price drop was larger, $24.62 to $13.70. That’s a 44.4% loss.
I think describing even 1/3-2/3 of that as “watching paint dry” is probably minimizing. Now, leverage up 5:1 and even 1/3 of that is pretty exciting.
Yes, you’re right. I stand corrected. Even 1/3rd the volatility of 60/40 during 2008 would be quite a harrowing experience.
Fortunately, if that kind of 2008 market volatility were to occur again, I’m much more quantitative and algorithmic now than I was in 2008, and I really couldn’t be more prepared for disaster if it strikes again. In fact our firm has already withstood the worst weekly start to the market in its history and even came out ahead.
Here’s my latest article on hvst: https://www.hvst.com/posts/63112-here-s-what-happened-the-last-8-times-the-s-p-500-lost-more-than-5-in-january-since-1950