Who is Risk Parity For?

On a practical level, who is RP for? While sometimes my enthusiasm leads me to think that RP is a great investment approach for everyone, in truth, it is most relevant for people in the "preserve" phase of their investment lives - when they need to live off of what they have saved.

To borrow the “Four Phase framework” from financial planning guru Michael Kitces, RP is most suited for the fourth phase, when preservation supersedes growth as the primary goal for a portfolio. In this stage, you’ve earned what you’ve earned, you’ve saved what you’ve saved, and the market has done as well as it was going to. You’re now in a position where you simply cannot gamble or overstretch yourself, and you have to make the numbers work, not taking out so much that you burn through it, but also taking enough so that you can live comfortably in your later years.

For those investors at the beginning of their working career, the middle, or even with say ten years left, Risk Parity may not be all that relevant. Investors in these stages are probably better off focusing on their savings rates above all and on progressing in their careers. For investments, volatility and withdrawal rates are not such a concern, so probably best to go with a heavy allocation to the asset class that will likely bring the best returns over the long run: stocks. I suppose, if pressed, there could be some value in a small allocation to Long-term Treasuries, to provide for when stocks decline and you need some “dry powder” to buy more when prices are low. Even a very small (1 or 2%?) allocation to commodities/gold could be a good idea, just  to get a sense of how the pieces fit together in a RP portfolio. But, by and large, when you are more than ten years away from retirement, balancing out sources of risk in a portfolio is not an overwhelming concern.

Then, as the mountain range of retirement that was once way off in the distance gets closer, turning to a more risk-balanced portfolio can be a good idea. To return to Kitces, Risk Parity could be worth exploring for investors in the later part of stage 3. In this transition phase, once can increase allocations to negatively correlated fixed income assets and non-correlated alternatives, perhaps on a gradual schedule of a percentage point per year increase, or something along those lines. It is best to transition portfolios slowly in order to avoid large tax consequences, to make sure you are not chasing returns, and to be certain that you’ll stick with your choices, so a five to ten year process of moving over your portfolio makes a lot of sense.

In the fourth stage, when the rate at which one can safely withdraw from their nest egg becomes the primary concern, is what Risk Parity is best suited for. In this stage, the investor might gladly sacrifice a semi-decent chance at a 10% portfolio return for a great chance of achieving 5%. The extra portion a RP investor is giving up because they are carrying heavier allocations to lower performing asset classes isn’t actually a sacrifice, it is the cost for the greater peace of mind that comes with knowing you are less susceptible to huge equity declines.

Speaking personally, my goal is for my nest egg to provide for my and my wife’s living expenses as we age, with whatever left over going to the kids. Whether that amount in the estate is X, 2X, or .5X, what my children will inherit is not my main concern; I just want to be sure that we will be able to comfortably draw from our amount. Risk Parity is, to my knowledge, the best investing framework to address those concerns.

Update: wrote a bit about how to use RP in the accumulation stage:

Is Risk Parity Suitable for the Accumulation Stage?
In a word: yes! Even though RP principles and portfolios are best suited for investors in the preservation stage of investing, they can still benefit investors in the earlier, accumulation-centered stages. Here are some points to consider, with some caveats…