Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:18]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez. Thank you, Mary, and welcome to episode five of Risk Parity Radio.

Mostly Uncle Frank [0:41]

Today's episode is the second of a two-part episode about the history of risk parity style investing. The first part of that was in episode three. If you recall what we talked about in episode three, we came up to the 1970s and the 1980s, where the 60/40 style of portfolio was come up with as believed to be the best kind of portfolio for long-term investing, but really showed some cracks during the 1970s and people were beginning to look around to see if there were better options. So what you will learn in this episode is that this style of investing first came into full flower in the 1990s. and was more or less formalized as a style in the first few years of the 21st century, and then since then has expanded in a variety of ways. So we have three questions today. They are follow-ups to the questions we asked in episode three. Question number one, how was the first risk parity style portfolio invented in the 1980s and early 1990s? Number two, How was this kind of investing formalized in the early 21st century? And number three, what is the status of risk parity style investing today? First question, Numero Uno. How was the first risk parity style portfolio invented in the 1980s and 1990s? Well, although there are still arguments about who invented risk parity, most people in the financial industry credit Ray Dalio and his firm Bridgewater. We can find this history in a monograph called the All Weather Story written in 2012 that I will link to in the show notes. Some of this is also contained in Ray Dalio's book Principles, but it's described best in the monograph. Now in the monograph, the question that Ray Dalio and his fellow officers at Bridgewater were asking in the 1980s is what kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different? What they ended up coming up with they called the all-weather portfolio, and it was a passive strategy. It was designed to be passive. In other words, it was the best portfolio they could construct without any requirement to predict future economic conditions. Now, how did they do this? Ray Dalio's background was in commodities, currencies, and credit markets originally back in the 1970s. When he set up his firm, the first thing they did is they were managing liabilities for corporations and looking at how best to minimize risk for those corporations with their various investments. And they began managing pension assets in the late 1980s. And some of the managers of these pensions came to them and were asking them questions like, what did Bridgewater think of a plan to use long duration zero coupon bonds in a pension portfolio? At the time, the typical institutional portfolio had and still has roughly 60% of its money invested in equities, and as a result, almost all of its risk is in that 60%. The rest of the money was typically invested in a number of different kinds of bonds and a few other small investments which were not as volatile. This type of asset allocation many investors had held at the time and remains the basic advice that many investors still adhere to, this kind of 60/40 stock/bond portfolio. But the idea that was presented is, well, why don't we change the bond allocation and make it a kind of bonds that are negatively correlated with the stock market that carry risk, but it's the opposite kind of risk. Now, Ray and his associates knew that holding equities made an investor vulnerable to an economic contraction, particularly a deflationary one, and the Great Depression was something like that. So the goal in this exercise was to try and find an asset allocation that didn't rely on predicting when this deflationary shift would occur, but would provide balance and security nonetheless. They trace this back to a 1990 memo to the manager of this pension fund who had raised this issue. And what they said in that memo is bonds will perform best during times of deflationary recession, stocks will perform best during periods of growth, and cash will be the most attractive when money is tight. The translation here is that all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional equity-heavy portfolio is akin to taking a huge bet on stocks, and in a more fundamental level, that growth will be above expectations. which isn't always true. So looking at the possibilities to hedge the risk, they took a look at how to match stocks with some other asset, and they found that equities needed to be paired with another asset class that had a positive expected returns, but would rise when equities fell and do so in a roughly similar magnitude to the decline in the stocks. So the memo agreed that the manager should hedge his risk with long duration bonds, long-term treasury bonds, that it would have roughly the same risk level as the stocks, and that would balance the two out. The idea was that investing in bonds when risk adjusted to the stocks didn't require an investor to sacrifice return in the service of diversification. Now, how did they actually figure this out and analyze it? Well, they had a brand new computer program at that time. That program was called Microsoft Excel, and it's the same Microsoft Excel that you and I can use today. Microsoft had released its first Windows-based version of that in 1987, and so using this tool, they began playing around with data sets to figure out how shifting asset weights would impact portfolio returns. And what they determined that with this tool, this new tool, and the data that they had, which was mostly proprietary at the time, that there was a way to balance out these portfolios. When they were also looking through this, what they also realized that if you had an environment like the 1970s, which was inflationary, it was much better to hold some commodities than simply to hold stocks and ordinary bonds. Because both of those suffered in the 1970s, as we discussed in episode three. Now they tried to determine why this worked the way it did. And what they focused on were basically two factors in the macro economy. They were looking at growth and inflation. And so they considered you could have four different kinds of economic environments. You could have an environment where both growth and inflation were rising. You could have an environment where both growth and inflation were falling. You could have an environment where growth was rising and inflation was falling. And you could have an environment where growth was falling and inflation was rising. And that in each quadrant of those four possibilities, different assets would perform better. So taking all that into consideration and working with our Excel spreadsheet program, they came up with four different groups of things that would perform better in different economic environments. And in a growth environment, they thought that equities and commodities would perform the best, and they determined that. in an inflationary economy, commodities and inflation-protected bonds would perform the best. In an environment where growth was falling, regular bonds would perform well. And in an environment where inflation was falling, regular bonds would also perform well in that scenario. And over time, they expanded this idea into different sub-asset classes and it became much more complicated. But to get to the all-weather portfolio, it was relatively simple and it was designed originally simply for Ray Dalio to put his family's assets into for long-term performance. At the time, Dalio described this portfolio as like inventing a plane that's never flown before. It looked right, but would it fly? This portfolio was never envisioned to be a product they would market. It was profound enough that nobody was doing it, but at the same time so straightforward that anyone could seemingly do it for themselves. And that's what's going to be important for us long term, is being able to do it for ourselves. So when did this really take off? It really took off in the early 2000s, and at that time is when they began to market it because after the boom years of the 1990s, the stock market did very poorly in the 2000s, and people were looking for something like this all-weather portfolio to use to protect their long-term assets. And so it was something they marketed to pension fund managers and others. So in the end, this portfolio is described as simple as building four different portfolios, each with the same risk, each with does well in a particular environment. One when inflation rises, one when inflation falls, one when growth rises, and another when growth falls relative to expectations. It's based on the idea that you don't know what the future is going to hold and which environment you're going to be in next. so it's better to have asset classes that perform well in each of those environments for the long run. Moving to the second question, numero dose. How is this kind of investing formalized in the early 21st century? Well, as we know, the early 2000s were a bad decade for the stock market with crashes at the beginning and again eight years later, so heavily stock weighted funds and portfolios perform pretty badly. Now since imitation is the most sincere form of flattery, hedge fund managers and academics began looking for alternatives like Ray Dalio's all-weather portfolio. And they began studying these kinds of portfolios and writing papers about them. So we get to a landmark paper written by Edward Qian in 2005 entitled Risk Parity Portfolios：Efficient Portfolios Through True Diversification. Now some pointed this paper as the first use of the term risk parity in print. I don't know whether that's true or not and people argue about it, but it's close enough for this history lesson. And this paper is something that we will link to in the show notes. And in the paper, Dr. Chen talks about the problem of diversification and defining it and dealing with it. He says, if you were advised to place over 90% of your eggs in one basket, would you think that is sufficient diversification? Apparently, many investors, those who invest in a balanced portfolio of 60% stocks and 40% bonds do, even though a 60/40 portfolio does not offer true risk diversification. And that comes as a surprise to many people that you're not really getting much diversification in just a stock bond portfolio like that. But what he found analyzing these kinds of portfolios is that stocks contributed 93% of the risk in that style of a portfolio and bonds only the remaining 7%. And he says, the message is clear. While a 60/40 portfolio might appear balanced in terms of capital allocation, it's highly concentrated from the perspective of risk allocation. And he goes on further in the paper. He says, based on the research, it can now be understood why a 60/40 portfolio is not a well-diversified portfolio. When a loss of a decent size occurs, over 90% of that loss is attributable to the stock portion. To put it differently, the diversification effect of bonds is insignificant in a 60/40 portfolio. And he goes on to suggest that the way to truly diversify a portfolio would be to reduce the stock portion and really focus on adding more diverse elements to it, including government bonds, including commodities, including other kinds of bonds. And he considers three variations of this style of a portfolio, one that is very conservative, kind of a base portfolio, that has 4 to 5% risk, similar to what a bond index has. He considers another portfolio that has stock market-like risk, and in order to get that kind of portfolio for this purpose, he added leverage, assuming that you would borrow money at about a 2 to 1 ratio, and then use that money to enlarge the portfolio to get a risk target of 8 to 10%. similar to the stock market or a 60/40 kind of portfolio. And then he talks about a third version, which, you know, the hedge fund managers would love, that is taking a strategy that has a more high degree of leverage and has a 60 to 20% risk profile that is similar to a typical hedge fund. And what he discovered is sort of translating these and analyzing all the data available that there would be excess returns in these portfolios over the standard stock market or stock bond mix that you would see. So the excess returns in the conservative version of this were 4.5%. The excess returns in the medium portfolio with stock market risk were 11.3% and the excess returns in the aggressive hedge fund style portfolio would be 22.6%. And this is analyzing data from the period of 1983 to 2004. And so this paper has become one of the most widely cited and quoted papers in financial management pertaining to risk parity. and if you look in any history of risk parity, this paper will be one of the first things that is cited. So what happened after that? This portfolio was successful. Ray Dalio's portfolios were successful. This set off a slew of copycats. Many hedge fund managers jumped in on the risk parity bandwagon. Many more papers were written. More variations of the risk parity portfolio were developed. and academics started paying attention to this and analyzing in a very mathematical way similar to the ones that had been used to develop modern portfolio theory itself. So we move on to the third question, numero trace. What is the status of risk parity style investing today? Well, the answer is that it's quite well developed as far as professional fund managers are concerned. There are lots of these papers being written and there are actually whole chapters in investment books about this. One of these chapters comes from a book published in 2018 called Multi-Asset Strategies：the Future of Investment Management. Now this is published by the CFA Institute, one of the most respected resources in the financial industry. For those of you who don't know, CFA stands for Chartered Financial Analyst. and a CFA designation is the gold standard for financial analysts. It takes about four years to complete the testing program and requires an additional four years of experience in the industry to be able to earn this certification. Now, the chapter in the CFA book that I'm referring to is entitled Risk Parity Silver Bullet or a Bridge Too Far. and it's written by a man named Gregory Allen. I will link to this in the show notes. The chapter traces the history of risk parity style investing in the context of modern portfolio theory, which as you recall was invented in the 1950s by Harry Markowitz and we discussed in the first half of this dual part episode, which is in episode three. And it provides the results of analyses on data for risk parity style portfolios, comparing them to ordinary portfolios from the years 1926 to 2010. Now, this study is regarded as perhaps the most careful and thorough analysis currently available in the literature about risk parity portfolios. What the people doing the study did is simulate the performance of a risk parity portfolio relative to a 60/40 portfolio over that 1926 to 2010 period in the US market. And they also analyzed 10 other developed markets globally from 1986 to 2010. Now in every case, the risk parity approach delivered higher risk adjusted returns than the traditional 60/40 portfolio. So it was better over longer periods of time, and it was also better over many different environments, different countries, different situations. What they also discovered was that for any given level of risk, a risk parity portfolio generated the same return as a standard mean-variance portfolio but with 60% of the volatility over the period. So if you have two portfolios and they're each expected to generate an 8% return, the risk parity version is going to be only 60% as volatile. And so we'll only have 60% of the drawdowns, potential drawdowns, that the other portfolio would have. And the chapter concludes by noting that as of December 2016, there is approximately $120 billion being managed in risk parity style portfolios. There are about two dozen firms that offer such products. We're talking about hedge funds here mostly, and we're talking about BlackRock and Janus and J.P. Morgan and Bridgewater and all the other big ones. Some of those funds are very conservative and some of them are very aggressive. People have taken this idea and applied it to a wide variety of styles of portfolios in terms of how much risk is being taken overall. So there's a wide variety of things that people have done with it. And there's a widespread use of risk parity style investing by financial institutions. So what is missing here as we get past 2018 and we're here in 2020. What's missing from this story is that these ideas have mostly not trickled down yet to individual investors. Now history suggests that it usually takes two or three decades and a couple of bad periods in the stock market for this to happen. Currently the area of individual or do-it-yourself investment is still largely populated by the old ideas of 60/40 portfolios, stock bond portfolios that have essentially been kicking around since the 1970s. So we're really focused on just stocks and bonds, and most individual do-it-yourself investors usually ignore the composition of the bond portfolio. They just buy a total bond fund and forget about it after that. Meanwhile, though, there are endless fixations by do-it-yourselfers on the stock portion of their portfolio. as to how much they should put in the total market, how much in the growth funds, how much in the small cap, how much in the international. And we hear these debates all the time, but they're really just talking about the entree section of the investment menu and ignoring the rest. What really hasn't sunk in yet for the individual investment community is something that we've actually known since 1986 and that Jack Bogle wrote about in Common Sense Investing, which is this. The overall performance of a portfolio is about 94% determined by the overall macro asset mix of stocks, bonds, and whatever other macro asset class you put in there. So as a practical matter, and I know lots of people don't like to hear this, micromanaging your stock portfolio is largely a waste of time. If you have an 80/20 stock bond portfolio or a 60/40 or a 100/0, it's largely going to perform the same as any other stock portfolio with that particular mix. And the variations are likely going to be mostly random noise or just luck. So unless you fancy yourself a stock picker, you'd be better off just choosing a few good low-cost stock funds for that stock portion of your portfolio and then just sticking with those for the long haul and starting to think more and more depth about the other parts of your portfolio. If you really want something different, you're going to have to look up from the menu of those stock fund offerings and see what else is available and how it might work better for you. Especially when you get to the point where you're going to live off your investments. Especially when we are talking about drawdowns and safe withdrawal rates. Because the safe withdrawal rate is not the same for various different portfolios. We hope to change the current fixation on stocks and bonds here, maybe just a little bit, and to broaden our horizons. We hope to open some eyes and fatten some wallets. And I think we just might be able to do that in the next couple years or maybe the next couple decades. By looking at the rest of this financial menu and doing some shopping and a little cooking for ourselves, we're going to come up with better mixes that will hold together better in the long term. And now I see our signal is beginning to fade. So tune in next time, which should be this Sunday, for our weekly portfolio review featuring this week's Portfolio of the Week, the Golden Ratio Portfolio. Thank you for joining me today. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [25:34]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.