Risk Parity Mindset #3: Build the Decathlete Portfolio

Being a successful Risk Parity investor means you're looking for something that performs well in a variety of economic situations. Think about constructing a well-rounded portfolio rather than a specialized one you have to change all the time.

This is a bit of a ridiculous premise, but play along: Imagine you were to be transported back in time 25,000 years ago, and though you would bring none of your modern-era knowledge or skills with you, your body would immediately transformed to that of a world class athlete in any Olympic sport. Which would you choose? You could…

  1. Become a sprinter. That would be nice since that would give you the best chance to evade a lion.
  2. Turn into a javelin thrower. All that arm strength would be great, since you’d be a great hunter.
  3. Or maybe transform into a long-distance runner, so that you’d have the stamina to cover a wide range when hunting and gathering.

All those would be nice, and you might take the additional stage of thinking which of those three tasks would be the one you’d face the most in your new daily routine on the pre-historic savannah of Africa. You’d try to guess what your life would be like, and then choose the best one to fit that life. I once read that early human life was mostly walking around looking for stuff punctuated by moments of sheer terror, so maybe the body type of a long-distance runner might be best. Since getting chased by a lion only happens once every few years, at the most, maybe don’t worry about being a sprinter, right? It hardly ever happens, so no use worrying about it. In the meantime, all those extra muscles need more food, and it seems like sprinters are always a millimeter away from pulling a hamstring, knocking you out of action.

What if we approach the question a bit differently? I may wind up doing all these things, though I don’t know exactly how much time for each. I’ll probably need all these skills, and want to be well-rounded;  maybe I won’t be the best at sprinting, javelin throwing, or long-distance running, but I can be solid in each. Wouldn't being a decathlete be best? In this imaginary scenario, bringing the skills and the body type to be suitable for the wide range of situations would be best to survive and thrive, and you wouldn’t need to predict what would be best.

Prepare, don’t predict

The lesson here for investing is that most investors get stuck trying to predict what economic situation is on deck, so that they can load up on the right thing. Looks like inflation is rising, now is the time to load up on TIPS. Ahh, looks like an interest rate hike is coming, so dump your bonds a.s.a.p. The Risk Parity investor, meanwhile, is trying to be like the decathlete, prepared for a wide range of economic environments without needing to think too much about what will be called for on any given day. In a RP portfolio, some assets are included to do well when inflation is low, others when inflation is high, some suited for times when the economy is growing and some for when it is not, just like the decathlete who can do a credible job with the event of the moment, whether its throwing, running, or jumping.

As an investor with a long time frame, you will experience these different economic phases, so it is important not to jettison the generalist approach just because it has been a year or two or whatever in one particular economic environment. There might be five or even ten year periods when equities seem to be inexorably going up, and commodities seem to be not doing much of anything at all. This was pretty much the 2010s, and I, for one, wound up curtailing my commodities exposure. While I didn’t sell the shares I had accumulated prior to 2010, I did basically stop buying more, which essentially means I passed up the opportunity to buy them at their cheapest. In late 2021/early 2022 as equities scuffle and commodities boom, I’m reminded how every asset class in a RP portfolio has its moment, if we can just be patient for it.

If I think about what type of investor personality may not be well suited for RP, it's those who suffer a lot from the Fear of Missing Out. If you have a RP portfolio with four assets A, B, and C, and A is skyrocketing while C keeps declining, it is very easy to fall to the temptation to dump C so that you don't miss out even more on the rise of A. The successful RP investor is one who doesn't fear that situation, and actually does the opposite: takes advantage of the success of A to load up on their position in C!