The roller-coaster ride the equity markets have been on for the last few years has led many investors to re-evaluate both traditional asset allocation models that have often fallen short of expected returns and alternative investment strategies that have failed to insulate portfolios from market losses. This has led to a growing interest in the global allocation and risk management strategy known as “risk parity.”
Risk parity is nothing more than 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 the main economic drivers—growth, inflation and sentiment. In addition, it entails targeting a consistent level of portfolio volatility regardless of changing market conditions.
Most typical asset allocation strategies direct a modest majority of the dollars in a portfolio, usually about 60%, to equity investments. That can be effective during periods of disinflation and positive growth, which describes the 25-year period ending in 2007, according to data from S&P. A longer view of financial history, however, shows that there are extended periods when equities typically don’t perform particularly well but other asset classes, such as bonds and commodities, generate acceptable returns.
For example, data from Barclays Capital, MSCI and Salient shows that if you had invested in the equity market in 1928 before the crash and held that investment all the way to 1950, you would essentially have made no money. Investors often fail to realize that they have anchored their expectations of the market on very recent financial history, and that these results are not necessarily indicative of the economic outcomes we could be facing going forward.
Many investors also fail to truly understand diversification. Diversification is not necessarily a function of the number of managers in a portfolio. It comes from the combination of the underlying asset classes and strategies. An investor may be employing dozens of managers through mutual funds, ETFs and other more complicated structures to purchase hundreds of individual securities, but all those managers are typically driven by what’s going on in the stock market. Investors who want to hedge against changing levels of growth, inflation or investor sentiment could potentially achieve better results by lowering the level of equities in the portfolio and increasing their allocation to commodities, interest-rate-sensitive bonds and other diversifying strategies.