Top 10 Risk Parity Resources: #3... Prince (2011)

"Risk Parity Is About Balance"

Another key article coming out of Bridgewater, this one by the Co-CIO. This accessible but still thorough write-up gets a little more into the theory behind RP, and the central question of how to deliver good returns, no matter the economic environment.

Read the original:

Risk Parity Is About Balance
Over twenty years ago Bridgewater Associates pioneered portfolio balancing concepts that came to fruition with the creation of the All Weather asset allocation strategy in 1996. Recently, several managers have begun to offer strategies based on some of these concepts, under the banner of “Risk…

Important Points for the RP Investor:

Page 2: Helpful timeline of the All Weather Portfolio’s development. Bolded phrase here: “reliable balance,” which is what Prince (author and Co-Chief Investment Officer of Bridgewater) calls the core of their approach. The portfolio achieves reliable balance based on a “fundamental understanding of the environmental sensitivities inherent in the pricing structure of assets.”

Page 3: Discussion of the problems with traditional asset allocation: it concentrates risk in equities in pursuit of higher returns. Every asset is susceptible to bouts of poor performance that can last a decade or even more as economic environments shift.

Pages 3-4: A risk parity approach, Prince argues, improves on this by canceling out risks over time, allowing for higher long-term returns. A portfolio of risk-adjusted asset classes can be structured so that their “environmental sensitivities reliably offset one another, leaving the risk premium as the dominant driver of returns.”

Page 4: Interesting and important part on how investors can’t just rely on the correlation numbers between assets to make allocation decisions. The numbers shift over time, and can’t be counted on too much. Instead, they have looked at more fundamental relationships between asset classes and the economy, as expressed in two factors: growth and inflation.

“Asset class returns will be largely determined by whether growth comes in higher or lower than discounted and whether inflation comes in higher or lower than discounted, and how discounted growth and inflation change. The relationships of asset performance to growth and inflation are reliable - indeed, timeless and universal - and knowable, rooted in the durations and sources of variability of the assets’ cash flows.” 

Page 5: A simplified look at risk allocation in a Risk Parity portfolio:

Simplified Risk Allocation grid

“The result of this balance if that the underperformance of a given asset class relative to its risk premium in a particular environment (e.g. nominal bonds in higher than expected inflation) will automatically be offset by the outperformance of another asset class with an opposing sensitivity to that environment (e.g. commodities), leaving the risk premium as the dominant source of returns, and producing a more stable overall portfolio return.”

Page 6: Two illustrations of how the different assets are supposed to balance each other out:

Page 7: A handy reminder for Risk Parity investors that there are the two paths with RP: using these principles, investors can target the same return but with lower overall risk, or target the same risk but with higher return (using leverage).

For more on Prince, here is a video of him talking about the All Weather portfolio and Risk Parity.

The All Weather Story
August 2016: The story of how Bridgewater Associates created the All Weather investment strategy, the foundation of the ‘Risk Parity’ movement.