My (Honest) Doubts about Risk Parity

Obviously, I am fully onboard with Risk Parity, but I do have some lingering doubts, if I may be honest. Since the goal with this blog is to research, test, and share insights about Risk Parity as an investing approach, I thought it best to be upfront about questions I have as I go deeper into the rabbit hole…

I have called this website “Risk Parity Chronicles” to reflect my process of exploring Risk Parity as a viable strategy for investing, especially in the decumulation phase. I want to investigate what RP is all about, test it over a period of time to see if it works, and share what I find out with anyone who wants to read it. Obviously, I wouldn’t undertake this project if I didn’t have a positive sense about RP, but believe me when I write that I still have some skepticism. If Risk Parity proves to be either a total sham, ineffective, inconclusive, or perhaps bested by another approach, I fully intend to say that here.

To that end, I am especially interested in finding, reading, and considering critiques of Risk Parity from professional investors, academics, or knowledgeable individual investors. This includes being on the lookout for newspaper stories, either from now or the past, about “failed” Risk Parity approaches and what we might learn from those experiences. I have published one such criticism already (“The Hidden Risks of Risk Parity Portfolios” by Ben Inker), and will publish more in the upcoming weeks and months.

I also harbor a few of my own doubts about Risk Parity that I want to follow up on as this project moves forward. I am especially interested in following and answering three questions about RP:

1)  “Is this time actually different?”

File this one under the category of common critiques that can be levied at any investment strategy, Risk Parity included. This is the basic idea that, while Risk Parity, or value investing, or buy-and-hold or whatever worked well in the past, we’re in a new era now and so can’t rely on old data. Backtests feature prominently in analyses of RP portfolios (this site’s included), with lots of credence given to how assets perform in the past, especially how they are correlated with each other. But, if we’re entering a new era where X, Y, or Z is going to totally change everything, then reliance on those old patterns is a loser’s game.

I don’t want to be too stubborn about this - obviously, when fire was invented, there probably was a person saying “this time is different” and they were 100% correct. Times do change, but these paradigm shattering changes are not nearly as frequent as the times you’ll hear that a paradigm shattering change is imminent. Relatedly, just because there is a valid reason to believe that times are different now, this doesn’t then mean we can be at all certain what to do with that information. People can be right about a paradigm shifting change right around the corner, and still be completely wrong about what to do about it.

The past twelve years have been great for stocks, save for the blip of March 2020, and really the past forty years have been good for bonds. Could these times be changing? Will inflation, which is already strong and gaining momentum as I write this, render the old models obsolete? Is the dominance of the US dollar in its last days? Is the relative stability of American institutions something we’ll soon look back on with nostalgia? Are the rises of cryptocurrency and decentralized finance harbingers of paradigm shifts to come? I have no idea about any of these things, but I will be watching to see how risk-balanced portfolios respond to changing conditions.

2) “RP is overly focused on correlation numbers, but what if those numbers change?”

Correlation - the measurement of how assets perform relative to each other - is indeed the keystone concept for Risk Parity. Like a value investor’s focus on an asset’s P/E ratio, or a growth investor’s interest in a firm’s year-over-year growth numbers, a RP proponent pays heightened attention to correlation numbers to figure out whether assets are positively, negatively, or non-correlated. Yet, these numbers, just like P/E ratio and YOY growth, change, and it's important to not get fixated on them.

The big assumption of RP is that negative correlation will continue to describe the relationship between equities and Long-term Treasuries. These have been negatively correlated from the period from 2008 until now (-.3), but this has not always been the case, either for long-term periods or (especially) for shorter time periods. One refrain you’ll hear is “In a panic, everything goes down except for correlation, meaning that when panic strikes, investors want to get rid of everything and so all asset prices crash together.

Yet while this may be true for a moment in time, it’s not really the case that this panic induced correlation spike really lasts. On Black Monday in 1987, for example, stocks crashed 22.6%, while bond yields fell and prices rose. In February and March of 2020, with the Covid pandemic at its early stages, bonds once again not only held but rose as equities fell (.

S&P 500 in blue; Long-term Treasuries in Black

The plural of anecdote is not data, of course, but the negative correlation between stocks and bonds does tend to hold up more than not. Even when bonds drift away from negative correlation with stocks, they don’t then mirror stocks as much as they are just unconnected to them. Still, Risk Parity proponents would be wise to accept the critique that they shouldn’t get too fixated on the correlation numbers.

3) “If Risk Parity is so great, why is it not mainstream?”

My thoughts turn to the Groucho Marx line - “I would never want to be in any club that would have me as a member” - in that, if Risk Parity is so logical, why would it need someone like me researching and publicizing it? How could it be so logical if it appeals to me, but not so much to others who are more qualified? There are 1000s of books written about investing, and 100s more every year, but Risk Parity seems on the fringe. I did a quick Amazon search: 9,000 books on Value Investing, and for Risk Parity…19. Of these 19, only 3 are actually about Risk Parity in English. It certainly seems logical to me, but am I missing something? Am I delusional? If I were delusional, would I even know?

In one of those three books about Risk Parity, Alex Shahidi notes the same disconnect, asking, “If Risk Parity is so obvious, why isn’t everyone investing this way?” (69). He provides a full slate of possible answers: 1) status quo bias in how finance is taught; 2) peer risk within the industry in the sense that it is better to be wrong in the same way as everyone around you than strike off in your own and be uniquely wrong; and 3) RP is somewhat more involved than a simple “stock for gains; bonds for safety” approach of the 60/40, and thus takes more convincing.

"For these reasons, the risk parity concepts may not become mainstream for some time even if the framework is sounder than the traditional approach. It can simply take an extended period of time to convert the conventional mix to something that may make more sense" (170).

At the same time, the financial industry is analytical, results-oriented, and for lack of a better world, greedy, and it certainly seems that if there were a time-tested way to make more money, or take less risk in doing so, then it wouldn’t be such a hard sell. I really don’t know, and as I move forward with my attempt to chronicle my investigation into Risk Parity, this remains an open question. I’ll be keeping my eyes and ears open for critiques of Risk Parity that may show my blind spots.