Okay, lots of disclaimers to read first, but if you are indeed thinking of transforming your portfolio to a Risk Parity-style construction, here are some simple steps to help you along.
Please Read these Disclaimers!
Major disclaimer: this site is for financial education, not financial advice. I'm not qualified to give such advice, anyway. The following information is just intended to provide insight to help you decide.
Second disclaimer: this whole site is about portfolio construction, so really, one measly blog post is not enough. Think of this post as just a way to start, not as a start-to-finish list of instructions.
Third disclaimer: any time you think of transitioning your portfolio, it is a good idea to do so very slowly. This is especially true if you will likely face any tax consequences by selling one thing in order to buy another. It is advised that you consult a tax professional if you are using regular brokerage accounts. One way to handle the transition if you are still in the accumulation phase is just to focus on buying the assets you may be short in as the money comes in, and avoid huge shifts.
Fourth disclaimer: Go slowly also to avoid getting over-excited about a particular asset class, and then transitioning your portfolio to take advantage of a temporary state of affairs. The tax consequences are one factor, but relative asset prices are another: you might be selling low and buying high. As I write this, commodities are booming, so there is probably some temptation to be more in commodities, but honestly, the time for this was two years ago, when they were out of favor, not now. If you are switching to a RP portfolio based on the commodities boom, you probably already missed it. Go slow…go slow…go s…l...o…w and avoid chasing returns.
With that in mind, and also that your portfolio should reflect you, not me, here is what I would do if I did want to transition to a Risk Parity-style portfolio,
Step 1: Do Your (Own) Research
There are lots of materials out there about Risk Parity portfolios and it's important to read and consider them so that you really understand what RP is all about. Quick to learn is quick to forget, so with important issues like your retirement portfolio, please make sure you’ve considered the strengths and weaknesses of a RP approach. Probably the worst thing to do would be to move out of a traditional portfolio, give RP a try for a year or two, and then go back because your traditional portfolio would have been better for that year.
Resources to consider are:
- Risk Parity Radio: Listen to it for a while, and go back to the early episodes for context.
- Portfolio Charts: The “insights” section on this great site has occasional articles on portfolio selection, and these are great for helping you think through what a good portfolio (for you) looks like.
- Optimized Portfolio: A wonderful site packed with insight, this one is a must read for any individual investor. As you think about changing your portfolio, try the “Investing 101” series of posts.
Of course, the resources on this site will help you get started, as well. If you have come to this site via this page, there are other sections to look at. Start with the “What is Risk Parity?” series, and then check out the Top 10 Resources for learning about RP, as well.
Step 2: Check out Various Sample Portfolios
Once you’ve got a good background, the next step would be to look at and analyze various sample portfolios already out there. Get a sense of their construction, their past results, and, most importantly, their goals. Look at their commonalities and differences; figure out what makes them unique and what is similar to others.
To get specific:
- Portfolio Charts: Go to the “portfolios” page, scroll down a bit, and there you’ll find “Professional Recommendations.” There are great write-ups of eighteen portfolios. Some of these are RP-inspired, some not.
- Optimized Portfolio: Here there are 52 “Lazy Portfolios,” each thoroughly explained. Again, this site covers traditional and RP portfolios.
- Risk Parity Radio: Tracks seven sample portfolios, all RP oriented (obviously). Also go back to episodes 2, 4, 6, 8, 10, and 11 to hear explanations of them.
If you haven’t seen them already, check out my ten test portfolios, of which three are totally unique and two more are adaptations of existing portfolios.
Step 3: Get Comfortable with the Tools
Part of the process of figuring out what your portfolio should look like is to jump right in and start backtesting them. Luckily, in this “Golden Age of individual investing” (as Frank Vasquez puts it), there are wonderful, free, easy-to-use tools to help you out:
- Portfolio Charts: Use the “My Portfolio” tool to play around with the numbers, see what adding or subtracting asset classes can do for return, volatility, withdrawal rates, and many more financial statistics. The advantage of Portfolio Charts is that there is a long data set (back to 1970), though it is not as fine-grained as the next on the list, since you can’t put in individual assets and the asset classes are rather broad.
- Portfolio Visualizer: This site has three tools for backtesting a portfolio. I tend to use “Backtest Portfolio” the most since it allows for selecting individual assets. The downside of this is that your backtest will necessarily be limited by the age of the youngest asset, so in many cases, your backtest will only be going back five or ten years. This site also has a “Backtest Asset Allocation” tool which is also great. It delivers similar information as the one on Portfolio Charts, though I like the look and feel of that one a bit better. To each their own, of course.
Step 4: Rough Guidelines to Assemble your Own
After all that, if you still want a basic recipe for setting up a Risk Parity style portfolio, here you go. Again, please keep in mind this is just financial education, I’m not qualified to give financial advice, and I don’t know anything about your particular situation. Can’t predict the future, either. Take all this with a huge 100-pound bag of road salt.
The Core: Equities. The typical allocation to equities will range from about 30 to 60%. As for what exactly, in my own portfolio I focus on low-cost, broad-based index ETFs, so things like VTI or VOO. Some have argued that maybe a sprinkle of Small-Cap Value and/or some International exposure can be good, and that seems fine within that 30 to 60%. If you want to invest in REITs, those can go here, as well.
The Counterbalance: Treasury bonds. These tend to have a negative correlation to equities, so they make up the yin to that yang. A reasonable range is maybe 20-50% of your portfolio in those. In my own portfolio I focus on Long-term Treasuries, since they typically are the most negatively correlated with equities. Short-term Treasuries are ok, too, if you really want to dampen volatility (and return). Just speaking for myself: I avoid TIPS and corporate bonds.
The Independents: Commodities and other alternatives. Next come some non-correlated assets, or things that will move up and down on their own. Gold and other commodities are the choices here, though you could also make the case for other assets in this portion such as directly-owned real estate (not REITs), collectibles like art, or private lending, among others. All together, a reasonable range for these alternatives is 10 to 30%.
The ranges are very approximate - play with the tools in Step 3 to see what changes when you increase or decrease a particular element. If you look at existing RP portfolios on this site, or Risk Parity Radio, you should get a sense of the variety of allocations within this very general framework.