The 60/40 portfolio has an expected return somewhere between stocks and bonds. An increase in equities above 60% yields a higher expected return, with a maximum long‐term return achieved at 100% equities. A reduction in stocks below 60% lowers the return projection all the way down to the estimate for bonds for risk‐averse investors who own 100% fixed income. The risk of these portfolios also scales up and down commensurate with the target return level. With this menu of choices, this is a very reasonable way to manage a portfolio.
A commonly used shorthand for determining the right allocation is to take 100 minus your age and allocate that amount to equities, with the remainder going to bonds. Following that rule of thumb, a 70‐year‐old should put 30% in stocks, while a 30‐year‐old, who has more time to ride the ups and downs of the stock market, can accept the greater risk that comes with a 70% equity portfolio as compensation for the higher long‐term return. If you're 30 and saving for retirement, there's a good argument to invest a majority of your portfolio in stocks if you're limited to these options. Although professional advisors may debate the percentages, few would argue with this general framework. The problem is that this logical sequence leads investors down a path that often results in poorly balanced portfolios that take unnecessary risk.
RISK PARITY FRAMEWORK OVERVIEW
Investors have the opportunity to build a much more efficient allocation: one that seeks higher returns with lower risk. The breakthrough comes from expanding the menu of available investments and evaluating the asset allocation decision through a different approach. These additional asset classes are very well known; have long histories; and are supported by extremely large, public, liquid markets. They have simply been ignored because of a lack of independent analysis and a dogged herd mentality. By completely reassessing the investment options, we are taking the critical step espoused by Ray of not starting at the same point as others but commencing at the most fundamental level.
Risk parity approaches the investment problem of earning high returns while minimizing risk from a completely different vantage point from that embraced by most investment professionals. We strive for what may seem impossible when viewing the task through the conventional lens and utilizing the traditional tools. In this book, I apply a basic two‐step process to answer the following question:
How can we build a simple, passively managed portfolio that can outperform equities over the long run with less risk?
We must begin from a blank slate and without regard to conventional wisdom, which many would immediately respond with a resounding “no way!” to the question posed. In the first step, we select from the appropriate asset classes that will enable us to construct an extremely well diversified portfolio that exhibits moderate risk. This involves focusing on assets that reliably perform differently in varying economic environments. The environmental bias is the emphasis in this step since that is the main driver of asset‐class returns.
In the second step, we structure each asset class included in our portfolio to earn high returns competitive with equities over the long run. Many investors may be astounded by the ease in which we can boost the expected return of certain asset classes that are traditionally considered to be low returning. By taking these steps, we are able to build a total portfolio that can outperform stocks over the long run with much less risk. In the next chapter we will dive into these steps in detail.
Note that the objective in this book is to describe the rationale for constructing a well‐diversified balanced portfolio that is designed to serve as a reasonable allocation for a long‐term investment. The mix does not factor in any views of what the future may hold or the current valuation of any market segment. Our risk parity portfolio is an expression of an efficient neutral allocation that is designed to weather inevitable and unexpected storms.
PEER GROUP RISK
There is one additional form of risk that is worth mentioning: peer risk. The three dimensions of risk (volatility, material loss, and an extended period of poor returns) are absolute in nature. Because of the two steps taken, (1) select diverse asset classes, and (2) structure asset classes to have equity‐like returns, the absolute risk is manageable. However, the bigger risk of adopting a risk parity approach is underperformance relative to the conventional mix. In other words, if the reference point is how the strategy is doing relative to how others are invested, then the risk of underperformance can be meaningful. After all, there is always the potential of falling behind by investing differently from others. This is sometimes called peer group risk in institutional investing and also holds true for individuals who compare themselves to peers and how the market is performing. I mention this because I have been using this investment approach for decades and have observed that one of the greatest challenges in holding on is living through periods of relative underperformance.
CHAPTER TWO
While I was on my journey to determine the optimal portfolio, one that could stand the test of time, Bridgewater introduced me to a conceptual discovery that provided a philosophical breakthrough. The traditional thought process of constructing a diversified portfolio joins two core concepts into one: risk and return. Equities have high risk and high return, while traditional intermediate‐term bonds have low risk and low return. When viewed through a conventional lens, these two options force the investor to have to choose between risk and return by deciding how much to invest in high‐returning stocks versus low‐returning but safer bonds. Accepting greater risk results in higher returns over time, and accepting less risk results in lower returns. There is a well‐established and, in many ways, commonsense compromise that you can't expect higher returns without taking more risk and you can't expect lower risk if you seek higher returns.
A simple shift in investment approach can completely change the logical path that can be followed to arrive at a more ideal portfolio solution. From a high level, there are two fundamental steps:
1 Which asset classes should we own to reduce risk?
2 How do we structure each asset class to get an equity‐like return?
We can consider risk and return separately. First, we should explore how to build an allocation of highly diverse asset classes to manage risk (without concern for the returns of those asset classes). By removing the return constraint and focusing purely on risk mitigation, we can open up the universe of viable options to maximize diversification. After we have identified the appropriate assets in which to invest, then we can structure each to have an acceptable expected return.
The goal of this chapter is to introduce this new perspective by first providing an overview of the conceptual framework. I will attempt to keep the discussion high‐level in the remainder of this chapter to lay out the roadmap. The following chapters will dive into each component with greater detail.
STEP 1: WHICH ASSET CLASSES TO REDUCE RISK?
There are a wide variety of asset classes within public markets that are readily available to investors. I had previously mentioned the traditional asset classes of equities and intermediate‐term government and high‐quality corporate bonds that make up the conventional 60/40 mix. Other popular market segments include lower‐quality, higher‐yielding bonds (which have come into favor as interest rates on high quality bonds have dropped to historic lows), cash (as a safe‐haven asset), and real estate (something that can appreciate like stocks but offers income like bonds).
To determine the appropriate assets to incorporate into our risk parity portfolio, I will begin the logical sequence at the most fundamental starting point rather than work off the traditional menu of