Risk Parity Mindset #2: Pursue True Diversification

While almost every investor agrees that diversification is crucial for a portfolio, many investors interpret it to mean variety (lots of versions of essentially the same thing) as opposed to dissimilarity. To be a successful RP investor, moving towards true diversification is key.

In a scene from one of my favorite movies, the Blues Brothers, Jake and Elwood have just decided to get the band back together in order to save their childhood orphanage. With all the band mates packed into a car, they drive for hours before finally finding a local honky-tonk bar, Bob’s Country Bunker. Their band is a Chicago rhythm and blues band, but Jake lies and says they are the “The Good Ol’ Boys”, the band slated to play that evening, whose name they saw on highway sign. Jake and Elwood definitely know this is going to be a stretch, but just to see what they might have to play if their impersonation is going to work, Elwood asks the woman behind the bar, “What kind of music do you usually have here?”

Her response is classic:

To tie this to investing, her response is similar to how many investors think about the diversity of their portfolios. They have a wide variety of assets, as they have Coke AND Pepsi, United AND Delta, or they have large American companies AND large European companies. The problem is, these really aren't all that diverse. United mostly matches Delta in terms of return and in terms of volatility, and though you do lower risk associated with individual companies (a.k.a. idiosyncratic risk), they mostly move up and down together. Just as what the bartender thinks is the full breadth of musical genres isn’t really, what many people think of as a diversified portfolio really isn’t all that diverse.

In terms of portfolios, just about all investors would agree that a diversified portfolio helps to obtain stable returns with less risk. But in practice, most investors have portfolios that concentrate risk with their equites, and then have little to balance it out in terms of other asset classes. Many people think they are getting diversification with their bonds, but then have high proportions of their bonds in corporate bonds, which actually experiences many of the same risks as equities. One of the main ideas in Risk Parity investing is that you have to have a broader range of assets to draw from, and also to investigate more closely where those sources of risk are. When constructing a Risk Parity portfolio, be on the lookout for true diversification, not just assets that may seem different.

Alex Shahidi, author of the book Risk Parity: How to Invest for All Market Environments, puts it this way (page 7):

"Most investors don’t really appreciate what diversification means. There appears to be an overemphasis on the number of line items as opposed to how diversifying each investment is relative to other holdings. They may think they are diversifying by allocating to assets with slightly different characteristics or to funds with different managers… but all of those allocations tend to be highly correlated to each other. In other words, the differences many investors focus on are largely immaterial”