Simplifying Risk Parity

A traditional 60/40 portfolio does not have 60 percent of its risk allocated towards stocks due to stocks contributing much higher volatility to the portfolio than bonds. The risk contribution for a 60/40 portfolio looks like:

Source: Wikipedia

All-Weather Strategy

The All-Weather strategy that Ray Dalio created is meant to weight portfolio holdings according to their contributed risk. If one were to balance stock and bond risks equally, the weightings would be as follows:

Source: Caixa Bank Research

The portfolio allocations for a truly balanced portfolio would look like:

30% stocks

40% long-term bonds

15% intermediate-term bonds

7.5% gold

7.5% commodities

If one were to follow this portfolio strategy, the overall results would look like:

Source: Created by author using PortfolioCharts.com

Simplifying Risk Parity

The main problems for implementing a portfolio allocation like this today are related to the bond and commodities allocations. The bond allocations have two issues related to credit risk and duration. I would argue the bond position should provide as much stability as possible, and that Treasury bonds are the most suitable candidates for risk-averse investors. The long-term treasury position also carries a lot of interest rate risk and would not provide stability in a rising rate environment. In an environment like the 1970s, this type of a portfolio is relatively unhedged compared to an intermediate bond position. I have found that a 55% allocation to intermediate Treasury bonds has similar performance with less credit and interest rate risk in backtests. This is likely due to the overlapping risks with high duration bonds and stocks, as well as, corporate bonds and stocks.

Spot commodity prices have performed very well historically, but commodity portfolios composed of futures perform very differently than spot over the long-run when their futures term structure is dynamic. Gold and commodities have a significant correlation and, for the purposes of mitigating inflation risk, can serve as a proxy for the commodities position albeit with higher volatility.

Source: Gold vs. the CRB Commodity Index | GoldBroker.com

Simplified Risk Parity Allocation Buckets

Enter the Simplified Risk Parity portfolio, which combines the bond positions into a 55% intermediate Treasury bond weighting and combines the commodities and gold positions into a 15% gold weighting. This results in weightings as follows:

30% stocks

55% intermediate-term Treasuries

15% gold

Source: Created by author using PortfolioCharts.com

This risk-parity portfolio has experienced a 3-6% real return, based on backtest results, which is in line with the All-Weather portfolio. There also happens to be less start date and interest rate sensitivity, lower drawdowns and volatility, higher consistency in real returns, and a slightly higher perpetual withdrawal rate compared to the All-Weather strategy. To top it all off, the funds in the simplified risk parity have a lower expense ratio and can be traded through current commission-free mutual fund and ETF offerings through top brokers. This is not to say that the Simplified Risk Parity strategy will be superior in these regards on a forward basis, but investors should not lose out by simplifying their holdings.

Assuming commissions, taxes, and expense ratios are 0%, the equity curves for the All Season Portfolio (Portfolio 1) and Simplified Risk Parity (Portfolio 2) look like the following:

Source: Created by author using PortfolioVisualizer.com

The annual nominal returns for the Simplified Risk Parity portfolio are shown below:

Source: Created by author using PortfolioVisualizer.com

A Quick Comparison Between Simplified Risk Parity And The Traditional 60/40 And 40/60 Allocations

It is important to add a real asset position to a diversified investment portfolio to protect it in a rising inflation scenario. The chart below illustrates during the 1970s that the simplified risk parity portfolio outperformed both 60/40 (portfolio 2) and 40/60 (portfolio 3) allocations and managed to keep up in the declining interest rate environment following it.

Source: Created by author using PortfolioVisualizer.com

Curve-Fitting Risk

Some may argue, especially Bogleheads, that this type of a portfolio is curve-fitted due to use of historical data to look at risk factors. I would argue this strategy is no more curve-fitted than Ray Dalio’s allocations due to the asset classes used in the simplified version targeting the same risk factors. I agree that previous conditions will be different than those we experience on a forward basis, but this strategy should continue to protect investors' capital by mitigating volatility and providing a real return in the range of 3-6%.

Disclosure:

I am/we are long VTI.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.