7 Things Advisors Need to Know About Risk Parity<br><br>
One of the principal reasons for this growing interest, according to Salient Partners CIO Lee Partridge, relates to the negative experiences many investors have had for more than 12 years with more traditional asset allocation models and additional frustrations with certain alternative investment strategies that often did little to ameliorate those experiences.
The basic concepts underpinning risk parity may generally be described as (1) an effort to distribute risk equally across key elements of a portfolio that are not only lowly correlated with one another but also linked in different ways to certain economic drivers such as growth, inflation or sentiment, and (2) the targeting of a consistent level of portfolio volatility regardless of changing market conditions.
Here are seven facts that advisors and their clients need to know about risk parity.
Source: Lee Partridge, CIO, Salient Partners
1. Diversification is the One 'Free Lunch' of Finance<br><br>
An equally weighted portfolio of the two assets described above would result in a return figure that is precisely halfway between the return on Asset A and the return on Asset B. By contrast, the volatility only increases by 0.71% (or 11.83% of the distance between the lower volatility Asset B and the higher volatility Asset A). Greater increases of return for lower increases in risk-AKA, the free lunch.
2. It's Not Always Apples to Apples<br><br>
Many investors believe they are adequately diversified by holding traditional asset allocation models that allocate 60% to stocks and 40% to bonds. The reality is that their portfolio returns are often being dominated by the stock component of that portfolio.
While only 60% of the dollars are allocated to stocks, over 95% of the portfolio's volatility is typically being determined by the stock allocation while a meager 5% is determined by the bond allocation. In essence, they are running highly concentrated portfolios that are typically betting on positive growth, benign inflation and positive sentiment to promote stocks as the dominant asset class.
3. Asset Allocation Drives Potential Returns/Diversification<br><br>
Investors who want to hedge against changing levels of growth, inflation or even investor sentiment could potentially achieve better results by lowering their allocation to equities-even if they only employed one concentrated manager-but increasing their allocations to commodities, interest rate sensitive bonds and certain other diversifying strategies. The response of different asset classes to changing economic conditions is generally higher than the response across individual holdings within an asset class.
4. Static Allocation Strategies Have Wide Variances in Risk Levels<br><br>
By contrast, the volatility levels in static allocation portfolios increase when market volatility levels or correlations increase and decrease when market volatility levels or correlations decrease.
5. Return Volatility is the Enemy of Long-Term Compounded Returns<br><br>
You might note that Investor B's annual portfolio returns are simply half those of Investor A. That said, some interesting things come from this analysis. The arithmetic return or simple average of Investor A's annual portfolio is 6% but Investor B's is only 3%. Nonetheless, Investor A had a total return of -6.40% while Investor B had a total return of +6.73%. This result offers a depiction of the damaging effect that volatility can have on a portfolio.
6. Risk Parity Targets Risk Exposure, Not Dollar Exposure<br><br>
7. Historically, Risk Parity Produces Lower Drawdowns Per Unit of Return<br><br>
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