Risk Parity Basics: Avoiding the Line Item Trap

Buy low, sell high. This mantra is the easiest, most straight-forward, non-controversial advice you can follow in investing, Risk Parity influenced or not. But what makes it so hard? Why do so many investors not only fail to do it, but actually do the exact opposite of selling low and buying high?

It’s a simple question with a complicated answer, but as I try to explain Risk Parity to beginning investors, time and time again I see that part of the answer is in how people view their portfolios. Are they whole things, or just collections of parts? Are we seeing the forest? Or are we looking at the trees?

I maintain that one of the best things an investor can do is start looking at the forest, and keep our heads up to avoid the “line-tem trap”: our tendency to view our portfolios in terms of their individual components instead of seeing our portfolios as a whole. Reason being that when we focus on the parts, it’s all too easy to make quick decisions based on recent performance, and hurt our progress towards long-term goals.

What makes the trap so troublesome is that, in a way, it is actually logical to succumb to it, yet your long-term success as an investor depends a lot on whether you do or not.

Example of the Line-Item Trap

Imagine a situation where your goals are to have a simple, four-asset portfolio that will achieve modest returns (let’s say 5%) without a lot of volatility. Below is what you settled on, along with how it has actually performed when you check in on it 12 months later:

Sample Portfolio

Congratulations, you got your 5% goal! Looking at how you got there, hmmmm…, what’s this? What’s that?

Wouldn’t it have been even better if you didn’t have commodities, and instead had devoted more towards equities, especially international ones? Can’t argue with the math: if you had put that 10% into international equities instead, you would have made $21,000 extra (13k more from those, and then no loss with commodities), representing a 7.1% gain. If only, if only…

So you respond by selling off commodities, and devoting that money to international equities. Heading into year two, you’re now at 60/40, with no commodity exposure.

The impulse is understandable, but what you have just done there is sell low and buy high. By looking at your portfolio at the line-item level and adjusting accordingly, you wound up changing your goals based on recent performance. If you hadn’t seen the breakdown, you would have been satisfied, but since you looked at it item by item, suddenly it’s a problem that you have a “solution” for. The seemingly logical solution is actually the exact opposite of what you would want in the long run. It is logical that you fell into the trap, but you’re still in the trap.

The Risk Parity response to the situation is counter-impulsive, which is one reason why RP portfolios remain hard for some people to really get behind, and even harder for some people to actually commit to. RP means fighting off those impulses, and even leaning the other way against them - to actually sell high to buy low.

Seeing the Forest

Without claiming to speak for every RP investor, here would be the different approaches to the sample portfolio after the one year:

  • For the example above, many Risk Parity practitioners would do nothing to their allocations, since the moves weren’t really that large enough to justify any changes.
  • Other RP practitioners using a calendar-based rebalancing system would sell off enough of the three successful assets to buy some commodities in order to bring the four assets back to their original allocations.
  • Finally, if the RP were using a rebalancing threshold approach, they might sell off only the assets far enough above their targeted allocation. With the numbers above, it is unlikely, but in more extreme situations, you could see a sale of international equities to buy commodities, for example.

I’ve posted about this trap before, but in slightly different terms. One of the three foundational principles of Risk Parity, as I see them, is that investors need to start thinking more of recipes, and less of the ingredients.

Risk Parity Mindset #1: Focus on the Recipe
Most of the talk about investing for individual investors is related to the ingredients of a portfolio, and very little to how the ingredients fit together. RP stresses the need to start thinking on a larger scale.

Here I used the metaphor of my young daughter at a dessert buffet, piling up her plate with every goody she came across. She took a few bites, got overwhelmed, then turned her eyes on the one dessert I had picked, one nice slice of Sacher Torte. If you thought of the Sacher Torte in terms of the ingredient, you’d rate it lower than the mound of everything good she had. If you attend to how the ingredients work together, then it’s clear the recipe worked.

Ilmanen on the Line-Item Trap

This came up again recently in the Antti Ilmanen book I reviewed a few posts ago. “Line-item thinking,” as Ilmanen puts it, works against the investor’s best interests: keeping a long-term horizon, diversifying, and maintaining humility in the face of overconfidence and impulsiveness. He recommends investors take a holistic approach to their portfolios, since

reviewing performance broadly helps guard against “line-item thinking,” which undermines the power of diversification. Typical casualties of line-item thinking include the most capital-efficient investments (those with a high standalone volatility but a small allocation) and the most diversifying investments. Such investments are likely to sometimes stand out and invite proposals for deallocation – leaving the portfolio worse off. Separately, as noted, myopic loss aversion undermines a long investment horizon. - Antti Ilmanen. "Investing Amid Low Expected Returns" (p. 168).

Investment managers are well-aware of the trap, and frequently couch it in terms of “line-item risk” - the idea that an advisor could put together a robust, well-diversified portfolio that is performing as expected, only to have a client go ahead and blow it up by requesting the removal of a particular element. Since the “customer is always right,” investment managers can feel pressure to acquiesce to the client’s impulses, even if the client would actually be better served by the original. Of course, some advisors just see their role as giving the client what they say they want, like the personal trainer who tells their client that the path to a lean body is doughnuts and Netflix (hey, works for me!).

In case you were wondering, this partially explains why, when you do see Risk Parity-influence investment products on the market, they are often wrapped together as all-in-one solutions. This allows the product to be judged as a whole, without it getting sliced and diced.

Some Disclaimers

One important caveat which outlines there may be times when the line-item trap with asset classes may be a safe hole to fall into: if you feel there is no future for an asset class. For portfolio-wide thinking to make sense, you depend somewhat on basic mean-reversion, or that if a given asset class is underperforming now, it will eventually catch up to historical expectations.

Lately, investments in digital currencies have tested that assumption, as there is a good chance that my earlier judgment that it was an asset class with positive expected return will prove misguided, if they haven’t already. In my test portfolios, I was moved enough by its recent collapse to cut my crypto allocation in the RPC Growth portfolio, and honestly, I may not be done. This is a bit of an extraordinary case, mind you.

Additionally, it is important that you not over apply the “rule” of investing into down assets when it comes to investments in individual assets, like ownership in a given stock. While the possibility that all the 500 stocks in the S&P 500 go to zero at the same time  are infinitesimally small (and if they did, you’d have bigger problems to worry about!), such is not the case with separate equities. The same logic that works for broad ETFs does not hold when you speak of assets like Enron, Pets.com, or maybe even Meta. You could be shoveling good money after bad, with those, with little certainty that they would ever recover. This is part of why I stay away from individual equities anyway, but if you do, keep in mind that what works for broad-based ETFs does not work everywhere.