Risk Parity Resources: Butler, Philbrick, and Gordillo (2018)

"Skis & Bikes: The Untold Story of Diversification"

Wonderful analogy of stores selling skis in the winter and bikes in the summer to explain the basics of diversification as the bedrock principle of effective portfolio construction. A must-understand concept for Risk Parity, cleverly and effectively presented.

Read the original:

There is a portion of the paper here, but the full version is available through their website. Click this link to get a PDF version of the full paper sent to you:

Whitepaper - Skis And Bikes: The Untold Story Of Diversification
Systematic investment strategies for advanced global asset allocation

There is also a shorter and simplified version here.

Important Points for the RP Investor:

As a teacher of 8th graders, I love a good analogy - something that is intuitive, efficient and can be easily visualized. My proudest one is comparing the Declaration of Independence to a break-up letter; if there is one thing 8th graders love it is relationship drama, and presenting the litany of colonist complaints against the Empire as a “Dear John…” letter to King George III really helps it make sense.

Turning to the principles of portfolio theory, this paper by the principals at ReSolve Asset Management just can’t be topped in their use of a great analogy. Butler, Philbrick and Gordillo use the example of an outdoor store that sells bikes in the summer and skis in the winter to show how one business can find sets of inventory that complement each other in order to maximize year-round sales and smooth out monthly income. Even if one element, says the ski side, is a lot more profitable than the bike side, the business as a whole is better off having both, since no matter how good the skiing is in that place, it ain’t happening in July.

The analogy is not entirely new - essentially, it’s a spin-off on Burton Malkiel’s analogy of the island with two distinct weather patterns (chapter 8 of “A Random Walk Down Wall Street,”), but the authors here do a great job of walking the reader through the analogy in order to get at the bigger picture: what proper diversification is, and why it plays such a key role in constructing portfolios.

I also cover some similar ground in my discussion of the second principle of Risk Parity - the need to pursue true diversification in a portfolio. My analogy there is that we should avoid “Country and Western Diversification,” which you may want to read:

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 nutshell, mine uses the Bob's Country Bunker scene for the Blues Brothers to remind investors to always seek true diversifying assets, not just two versions of basically the same thing.

Interested readers may also like my blog post on how we need to be clear with what we mean by diversification and whether we are talking about variety or dissimilarity. When it comes to desserts, Baskin-Robbins has a lot of variety, but nothing besides ice cream; Costco has a lot of dissimilar desserts, but not a lot of variety for any particular type.

Back to this paper: I wanted to include this as a Risk Parity Resource since it so effectively puts the analogy into practice. The authors work from first principles - what diversification is and why it's important, the theory - all the way to assembling a model portfolio based on the principles.

Usually with these RP Resource reviews, I summarize the paper since I know that while you, lovely readers, might read the blog post, you might not exactly have time to read the original paper. In that case, I summarize them to try to convey the main points.

In this case, the full version of the paper is one that deserves that extra step. It's 29 pages, but a light 29 pages, with handy graphs that build the argument from first principles. If that’s too much of an ask, Butler, Philbrick, and Gordillo also have written a shorter version which focuses more on the analogy and the basic principles, but doesn’t get much into how to actualize those principles in a portfolio. Both versions are included above.

If you just want the highlights, though:

Page 3: Graph of the hypothetical store selling skis and bikes over the course of a year. In case you were wondering, that’s basically my logo, too!

Page 5: Graph showing return vs. risk for global asset classes. This is an important point that goes back to Ray Dalio and other O.G.s for Risk Parity: the risk-adjusted returns for various asset classes are more or less similar, and you can achieve higher expected returns by taking on more risk.

Pages 7 and 8: a more realistic version of the simple graph on page 3, this one showing two hypothetical portfolios separately on p. 7, and then combined on page 8. This is a clear demonstration of the benefits of diversification. By combining two uncorrelated assets, each with positive expected return, you lower total portfolio volatility. The graph on page 10 elaborates on that example, this time with five assets. By the way, the discussion here, from about page 7 to 10, is “can’t miss.” I’m probably preaching to the choir with most of my readers, but this is the key concept to get across to anyone who is interested in constructing better investment portfolios.

Pages 11 to 13: These take a step back to look at typical portfolios (such as the Classic 60/40), and where the lack of true diversification shows up: when equity risk, the main source of risk in most portfolios, rears its head.

Page 15: Discussion of “diversification ratio,” a handy statistic for figuring out the benefits of diversification in a given portfolio. It’s a conceptually simple stat (average of the individual volatilities in a portfolio divided by the actual volatility of the portfolio as a whole), but can be hard for DIY investors to calculate, so just keep in mind that the lower the correlation is between the assets in a portfolio, the greater the diversification benefit. Sorry, that was a mouthful - better just read this section yourself.

Page 18: Continues that discussion, but also includes one of the most helpful diagrams in investing - their bullseye chart of “Asset Class Behaviours in Different Inflation and Growth Environments.”

This graphic is an improvement on the original in the genre, Dalio’s two by two square (see here, about halfway down), since it shows the effect size of various assets in different economic scenarios. I have no tattoos, but if I did, this is what I would have on my shoulder!

Pages 21 to 28: In section 5, the authors walk the readers through the construction of a diverse Risk Parity portfolio based, and this is a great section to read to figure out how the pros do it. They explain how, if you target the same volatility, you can increase expected portfolio return with a properly diversified portfolio. On page 28, they calculate that a Strategic Global Risk Parity portfolio would have returned 2.65% more than a Global 60/40 over the time period of 1991 to 2017.

(Relatedly, they don’t go over it as much, but you could use the same basic idea to match the 60/40’s return but with a lot less volatility along the way. These are the two paths of Risk Parity, as I explain here).

In sum, this is a great paper for the DIY investor. Do yourself a favor and read the whole thing - it’s worth it!

Other Resources Related to this Paper:
I’ve mentioned ReSolve and the work of Butler, Philbrick, and Gordillo a lot on this blog and on Twitter, and with good reason. They are doing great work and have been such a great resource as I’ve fallen deeper and deeper into the wonderful rabbit hole that is investing, portfolio theory, and Risk Parity.

You might like their podcast:

Risk Parity Resources: ReSolve Riffs/Gestalt University
A can’t miss investing podcast that frequently touches on Risk Parity, this combined show from ReSolve Asset Management will broaden your knowledge base across a wide range of topics. The personable hosts create rich conversations that will push your thinking in lots of new directions. In podcast f…

And their “Return Stacking” paper, written with Corey Hoffstein:

Risk Parity Resources: Gordillo et al. (2021)
Not exactly RP, but adjacent to it. This is an industry white paper about one way to use leveraged funds to free up space in the portfolios to make them more balanced. Authors are influenced by Risk Parity principles, and provide ideas for implementation, even though they call it something else.

Don’t forget to give their website a look, especially their “Research” page where their various white papers, videos, and more are assembled. This page is like Christmas morning for the Risk Parity curious!:

Systematic investment strategies for advanced global asset allocation