Risk Parity Mindset #1: Focus on the Recipe

If you’ve ever taken a 6 year-old to a hotel buffet and given them free rein over the dessert bar, then you can imagine my daughter’s choices in Austria a few summers ago. Mint chocolate chip ice cream, topped with chocolate mousse, a kind of brownie, and, oooh, are those gummi bears? Better dump a scoop of those on there, and oh yeah, some  chocolate and caramel sauce, too. At first, there was such tremendous excitement as she sat down with this wonderful concoction, but truth be told, after 3 minutes, she was done. The gummi bears froze, and the mousse, sauces, and ice cream all melted and blended into one another as a brownish-green mush. It was overly sweet, looked gross, and was totally overwhelming, so she started poking around my plate for the artfully done Sacher Torte.

Let's extend the story by imagining that we had tried to deconstruct that Sacher Torte by getting her to taste test the ingredients of that on their own. She’d be totally fine with the apricot jam, but dark chocolate? Yuck. Flour? Tastes dry and powdery, no way that it's better than gummi bears. Eggs? Aren’t those for breakfast? Yet combined in the right way, they produced a wonderful dessert, which she finished off.

Sorry for the trip down memory lane, but it’s a quick illustration of the way most people invest — more or less the same way as my daughter tackled the buffet. There is a tendency to focus on the individual investments so people add a little bit of this or that, as the feeling strikes. Tech stocks look like they’ll do well this year, let’s add those, and oh, the real estate market is picking up, let’s add some REITs, and so on. At the same time, other investments can be quickly skipped over since they don't seem to be quite sweet enough, maybe things like bonds because yields are low. In the same way that the kid chef is going to wind up with a blob of chocolate mess, made up of “good” things but that don’t produce much of a dessert when combined, the investor will wind up with a bunch of random stocks, and not much of an actual portfolio.

One big mindshift needed for successful Risk Parity investing is that it is better to start thinking of the creating that wonderful Sacher Torte as opposed to the random melange of sugar - to start thinking of the recipe as opposed to the ingredients. In Risk Parity investing, it is crucial to understand how the different pieces work together, and how even elements that may not be so appealing on their own, can still serve an important function when combined with other things. As you look through the sample portfolios and read about the asset classes of which they are composed,  keep in mind that Risk Parity investing is above all about how they balance and blend.

My unscientific poll of CNBC over the years is that 99% of the talk is about individual ingredients: is it better to hold this tech company or that one, should we buy, sell or hold this domestic car company, or do we go for index fund A or index fund B. This discussion is not unimportant, but the average investor would be better off with that as 1% of the conversation and the blend of asset classes as the other 99%.

Ingredients do matter, but our focus on them as individual investors is out of scale. To return to the Sacher Torte,  creating a good one certainly depends on using high-quality chocolate, fresh eggs, and vibrant apricot jam. Good RP portfolios similarly depend on the right investments within the equity portion, or within the negatively correlated fixed-income portion, for sure, but even more so on the proportions between those broad asset classes. Thankfully, you need not be as precise as a trained pastry chef to put together a good quality portfolio, but it is wise to start primarily thinking of proportions and to not discount certain ingredients at first glance. Although some ingredient may seem unpalatable, it might serve an important function. This will help create balance and cohesion within your portfolio, so that it can better match your situation and goals.