Quick summary of six milestones in the development of Risk Parity as an investing approach, from Markowitz to Dalio.
Harry Markowitz publishes “Portfolio Selection” - a landmark paper in the field that led to Markowitz’s reception of the Nobel Prize for Economics in 1990. This paper launched Modern Portfolio Theory (MPT), which concerns how the combination of assets in a portfolio can lower overall portfolio risk or increase overall portfolio return. Markowitz took two assets: stocks (higher return, higher risk) and bonds (lower return, lower risk), and created a framework for understanding the different combinations of them in a portfolio. Markowitz did not use or even support the idea of risk parity, but his ideas are the first inklings of a Risk Parity approach.
Financial advisor and author Harry Browne publishes a series of books in the 1970s advocating an approach to investing along the lines of a risk parity approach, though perhaps unwittingly so. Browne promotes the “Permanent Portfolio” with a quarter of one’s assets allocated to four asset classes: cash, gold, stocks, and long-term bonds. Although Browne doesn’t make much of a dent in the investing world, Browne is a bit ahead of his time with his recognition that it is better to prepare your portfolio for whatever lies ahead rather than try to predict exactly what conditions lie ahead.
This was a very weird decade for investment, and a time period that shook up some of the standard investment approaches. There were high nominal stock returns and high nominal bond returns, but when accounting for inflation, investors in both of these asset classes lost ground over the decade. Stocks got killed across the board, and the only bonds that did passably were short-term, since they could adjust with the rise in rates. Meanwhile, the ban on private ownership of gold in the United States, which started in 1933, was repealed in 1974 and took effect at the start of 1975, thereby bringing this asset class back into practical existence. The price of gold went up in the decade, as did commodities and real estate since they were able to keep up with inflation, bringing these alternative asset classes to more prominence and helping people think beyond just stocks and bonds.
Ray Dalio of Bridgewater Associates launches the All Weather fund, the first portfolio created following the principles of what would later be known as “risk parity.” Dalio doesn’t use the term at the time, though the All Weather fund is widely acknowledged as introducing the concept. Dalio’s central observation is that traditional 60/40 portfolios aren’t that diversified since almost all of the risk is captured in the stocks. To create a portfolio that can be sustained in any type of economic environment (hence the name “all weather”), Dalio invests in a broader range of asset classes which are (ideally) risky in ways that are uncorrelated with another. Dalio also uses leverage with certain asset classes to bring their return and risk expectations in line with asset classes. The fund is a tremendous success, spawns a host of imitations, and Dalio becomes associated as the founder of Risk Parity.
Edward Qian, Chief Investment Officer at PanAgora Asset Management, publishes a white paper called “Risk Parity Portfolios: Efficient Portfolio Management through True Diversification” that uses the name “Risk Parity” and describes its basic approach. Qian defines Risk Parity portfolios as a “family of efficient beta portfolios that allocate market risk equally across asset classes, including stocks, bonds, and commodities.” Qian also develops the central insight about diversification - that most investors aren’t as diversified as they think, as most of their risk is held in the equity portion of their portfolio.
One of the limitations of the All Weather portfolio is that it relies on research and investment strategies that are beyond the scope of the average personal investor. In working with author Tony Robbins, Dalio lays out a version of the All Weather that everyday investors can implement, called the All Seasons portfolio. It is 30% stocks, 40% long-term bonds, 15% intermediate-term bonds, 7.5% commodities, and 7.5% gold. Due to the popularity of Robbins and his book, Dalio’s ideas reached a wider audience.