By Nicholas Bryan
Most people may not have heard of risk parity, but are fairly familiar with the idea of diversified portfolios. What has been preached for decades in classrooms and among portfolio managers is the idea of a 60/40 portfolio. A 60/40 portfolio is one that contains 60% of equity and 40% bonds. The 60/40 method minimizes an emphasis on risk. Typically, in a 60/40 portfolio the 60% equity accounts for around 90% of the risk of the portfolio. This strategy is not advantageous for risk-averse investors. However, the risk parity strategy offers a solution for investors to stay diversified while taking into account risk factors.
Risk Parity Investing Strategy
The risk parity strategy says that all asset classes should have the same marginal contribution to the total risk of the portfolio. In other words, it is an equally weighted portfolio where the weights are measured by risk and not asset classes. This means most of the allocation of a portfolio will be towards more risk-averse assets. A common misconception is that the risk parity strategy will hurt a portfolio’s returns. However, equities thrive in low inflationary and high growth economies, bonds do well in recessionary economies, and commodities do well in inflationary environments. This allocation allows for the downside of different aspects of a portfolio to be mitigated by the upside from another asset class. For example, historically a fund with 10% volatility has netted an 11% return compared to a 5% return on a 60/40 portfolio.
Alternative Investments Offset Losses
The problem currently with risk parity is that in times of high inflation, bonds prices can become volatile leaving a large chunk of a portfolio underperforming. This is where alternative investments come in as a way to help offset some of those losses. Alternative investments in commodities, such as agriculture, can help to offset this cost. The current suggestion among experts to achieve risk parity is to have 20% allocated to stocks with the rest of the weight of the portfolio divided evenly between alternative investments and bonds.
Although using risk parity can seem daunting, it can prove to be very helpful in properly diversifying a portfolio. Many people think by employing the 60/40 strategy they have mitigated any idiosyncratic risks, but to fully achieve this goal, an investor must focus on the level risk associated within each asset class. Risk parity allows an investor to divide the risk evenly among all asset classes without taking into account the numerical weight each asset class contains. In the end, this structuring will leave a portfolio strong enough to withstand inflationary pressures, as well as future recessionary climates.