Is Risk Parity Suitable for the Accumulation Stage?

In a word: yes! Even though RP principles and portfolios are best suited for investors in the preservation stage of investing, they can still benefit investors in the earlier, accumulation-centered stages. Here are some points to consider, with some caveats…

In an earlier post, titled “Who Is RP For?,” I made the case that Risk Parity is primarily suited for investors who are in the “preservation” stage of the investment cycle: they have earned what they have earned, they have saved what they have saved, and the market has done as well as the market was going to do. After investors have passed through those earlier stages of earning, saving, and investing, they can then turn to Risk Parity as a great way to manage investments when the primary concern is how to live off those accumulated assets. In the early stages, earning power, savings rates, and raw investment returns are the dominant financial metrics to think about; as one moves toward preservation, then stability of the portfolio and the proper withdrawal rates are added to the list.

In that post, I also mention that RP principles could still be applied to investors before the preservation stage. What, then, does RP have to offer for investors in the accumulation stages?

First off, I like to always keep in mind that for 90% of people, low-cost, broad-based, no-frills target date funds such as those at Vanguard are just fine. If you’re reading this and  new to investing, then the best general, one-size-fits-most advice would probably be to just stick to those. To paraphrase Jack Bogle, the founder of Vanguard, yes, there are some things better out there than boring target date funds, but also many, many things which are far worse. If Risk Parity seems too complicated, too much work, or might be too hard to stick with, I would disagree (this whole blog is to try to alleviate those concerns!) but also say that those doubts are enough to indicate that RP is probably not the right thing at that time. Until it is, go with Target Date funds.

Second, keep in mind that there is no such thing as THE Risk Parity portfolio, or THE Risk Parity way to do things. Think of RP more as an approach, an orientation, or maybe a mindset. Some RP techniques or portfolios may not be suitable for you, so it is good to stay open to the possibilities instead of rejecting the approach based on just one element. To give an example, Ray Dalio’s All Seasons portfolio is probably the most well-known example of a portfolio built on Risk Parity principles, but a 30-year old looking at it might look at the 55% allocation to bonds might (rightly) conclude that it wouldn’t be a great portfolio for them. No disagreement there, but there is way more to RP than the All Seasons.

Third, though RP can improve portfolios in the early stages of investing, it is definitely not the only way to do that. While I don’t agree with everything JL Collins or Paul Merriman says, or everything you can find on the Bogleheads forums, those are all great places to learn about general investing and their advice may be more suitable for your situation than Risk Parity, which is fairly specific. My advice would be to become familiar with those perspectives (among others) first. Then, when the investor is ready, Risk Parity will appear!

With that said, here are some RP approaches that may help someone in the accumulation stage:

Start Paying Attention to Correlation

I’ve found that many DIY investors have lots of assets that essentially do the same thing, but then call that diversification since there are indeed slight differences. Save some time and energy fretting over whether to hold a large cap value fund or a mid-cap value fund – they’ll probably do about the same. Instead, pursue true diversification, not superficial diversification. One real world example would be with one’s bond allocation. Many people use a bond fund like VBTLX to “smooth the ride” as JL Collins suggests. If that is indeed your goal, then try bonds that are more likely to do that, i.e. Long-term Treasuries. VBTLX contains more corporate bonds, which may have higher returns, but act like stocks. But, corporate bonds don’t smooth the ride; Treasuries do, and you can see that when you start looking at correlation.

Key Concept in Risk Parity: Correlation
If RP has a secret ingredient, it is correlation: the degree to which two assets move in relation to each other. It comes up everywhere in this blog and elsewhere in the Risk Parity literature, so perhaps a step back to officially define and explain it is important.

Consider Experimenting with Embedded Leverage ETFs

Maybe, just maybe, experiment a little with embedded leverage ETFs such as NTSX. Instead of a 60/40 stock/bond split, one could devote a small amount of money to NTSX which uses a very modest amount of leverage (within the fund itself; you, as the investor, don’t use leverage to get it) to essentially get the performance of a 90/60. I do not own NTSX myself, but if there were an ETF to get started with, NTSX might be the one.

Look Beyond the Traditional Portfolios, and See How Alternatives Compare

Even if RP portfolios are primarily focused on investing for drawdown, there are many which can go  toe-to-toe with traditional portfolios in terms of return (while having lower volatility, to boot!).  Look around for portfolio alternatives, and be open to portfolios that go beyond a sliding scale of stocks to bonds, such as the 60/40, the 80/20, the 87/13 or whatever. Portfolio Charts, Optimized Portfolio, and Risk Parity Radio are all fantastic sites and have ways to compare portfolios. The test portfolios tracked here are bunched into three groupings, each with a traditional benchmark portfolio for comparison purposes (60/40, 80/20, and 100% equities).

Overview of Test Portfolios
Risk Parity Chronicles tracks seven sample portfolios and three benchmark portfolios, in groups according to their levels of expected volatility. The portfolios are summarized and compared here; see subsequent posts for in-depth looks at each.