User:Stocksurfer/Risk parity portfolio

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Also: All-Weather Portfolio, Bridgewater All-Weather, Ray Dalio All-Seasons Portfolio

Risk parity is a methodology to derive an asset balance through numerical means that focus on the balancing the risks across asset categories and/or across the expected performance of those assets in four different economic environments. It is geared to portfolios that are broadly diversified beyond stocks and bonds, for example when a portfolio contains 15 or more asset classes.

Risk parity portfolios were popularized by Bridgewater Associates and Ray Dalio in particular.[1] They used the term Risk Parity to describe the All Weather Portfolio -- a specific commercial offering -- as well as the All Weather strategy.[2] Tony Robbins popularized a simplified version of the All Weather portfolio called All-Seasons portfolio in his book MONEY Master the Game: 7 Simple Steps to Financial Freedom. [3], but while this portfolio was produced in conjunction with Ray Dalio many people disagree that it appropriately reflects the All-Weather strategy.[4] [5]

To quote Ray Dalio: "Risk parity is the means of adjusting the expected risks and returns of assets to make them more comparable. This is done for the purpose of creating a better diversified portfolio that will have a better return-risk ratio than would otherwise be possible. Once the better diversified portfolio is created and the return-risk ratio is improved, the portfolio can be geared to the desired level of risk and return." [6]

There are 3 conceptual parts to a Risk Parity All-Weather portfolio:

  1. The notion of Risk Parity, an investment strategy that balances risk across a number of asset classes.
  2. Recognizing four economic environments defined by the four possible combinations of: inflation is above or below expectations priced into the market, and economic growth is above or below expectations.
  3. An implementation of a portfolio that uses broad diversification across asset classes to cover all four economic environments, to select an asset allocation based on equalizing the risk across the asset classes and economic environments, and typically to leverage the portfolio to achieve the desired level of rains vs. risk.

Implementation comments

A simple risk parity portfolio ends up having a rather low expected mean return. For this reason, Bridgewater's All-Weather portfolio uses leverage to increase the return. The use of special assets as well as the use of leverage makes it difficult for a retail investor to replicate the all-weather portfolio:

  1. the management complexity of balancing risk exposures
  2. the operational complexity of leveraging low-return assets: one needs to manage a portfolio of rolling futures contracts and/or access the repo (repurchase) market

Tag suggests [7] that a possible simple solution is to increase allocations on long duration nominal bonds (EDV), long duration inflation linked bonds (LTPZ), gold (IAU), and commodities (GSG). A possible complex solution is to open an Interactive Brokers account and gain the appropriate risk exposure through equity, interest rate, and commodity futures. This is expensive analytically and far beyond the capabilities of retail investors.

Economic Environments

Variations on Risk Parity

The concept of Risk Parity can be implemented in a number of different ways, which diverge in the way risk is measured and how it is balanced.

Inverse Variance

Equal-weighted Risk Parity (ERC)

Clustered Risk Parity (CRP)

Concrete example

This section should be redone using portfoliovisualizer

This concrete example is meant to illustrate the mechanics of calculating risk parity. It is not meant as an endorsement of a specific asset allocation.

Azanon converged by 9/20/2017 on the following portfolio in the Improving the Dalio/Robbins All-Seasons Portfolio thread:

  • 25% Vanguard Mid-Cap Value ETF (VOE)
  • 10% Market Vectors Emerging Mkts Local ETF (EMLC)
  • 20% Vanguard Extended Duration Treasury ETF (EDV)
  • 30% PIMCO 15+ Year US TIPS ETF (LTPZ)
  • 7.5% ETFS Bloomberg All Commodity Strategy (BCI)
  • 7.5% iShares Gold Trust (IAU)

Naive risk parity

The background for the naive risk parity comes from Dynamic Asset Allocation for Practioners:Part 4: Naive risk parity [8] or Risk Parity for Dummies.[9] Naive risk parity ignores correlation between assets.

First retrieve data about the assets from Portfolio Visualizer's Asset Correlations calculator. Using this link returns a complete correlation matrix out of which we only need the monthly standard deviation column to calculate asset weights:

Ticker stddev 1/stddev Kt weight
VOE 4.04% 24.75 12.77%
EMLC 2.92% 34.25 17.67%
EDV 4.52% 22.12 11.41%
LTPZ 2.73% 36.63 18.90%
BCI 2.37% 42.19 21.77%
IAU 2.95% 33.90 17.49%
0.005159 sum: 100.00%

where Kt=1/sum(stddev) and weight=(Kt/stddev)

Note that due to the fact that BCI was created in April 2017 the data for the above calculation. In other words, this is just a first step, we're far from done.

Risk Parity with Covariance

To calculate the asset allocation of a risk parity portfolio taking into account the correlation between assets use the spreadsheet from Portfolio Wizards. Start by downloading the data from the Portfolio Visualizer noting that this link retrieves 3 years of data by substituting DJP for BCI.

The extend the spreadsheet to support 6 assets instead of 3 and plug in the correlation matrix on the inputs sheet as well as the annualized standard deviation:

Correlation Matrix.png

Then, after fixing the matrix size on the calculations tab, go to the results and run the solver:

Risk Parity Portfolio.png

See also

Notes

References

Further reading

Introductory material, e.g., why risk parity and all-weather:

More detailed discussions:

More specific how-to and calculations:

External links