Risk Parity Strategy

[DaKini]

Very recently i btiefly heard from a risk parity strategy. Does anybody know what this is and what do you think of it?

[hodedofome]

Google is your friend.

I'll sum it up for you by saying that you essentially take a diversified portfolio of asset classes (stocks, bonds, commodities, real estate) and instead of weighting them 25/25/25/25 or 60/40 or 50/50 or whatever it might be, you weight them according to their volatility. This is because in a standard 60/40 stock/bond portfolio, stocks make up most of the volatility in the portfolio.

Since bonds are typically less volatile than stocks, you would have more bonds in the portfolio. The volatility of the entire portfolio ends up being lower than just a standard 60/40 stock/bond portfolio and so they use leverage to bring the volatility equal to 60/40 or 100% stocks or whatever you want. By then it's supposed to have a higher return than stocks but with equal volatility.

Here's an example by using risk parity for US Total Stock Market fund and US Total Bond Market fund as compared to Vanguard's 60/40 stock/bond fund. It rebalances quarterly and most of the time the weighting is 70-80% stocks and 20-30% bonds. Volatility is much lower than 60/40, drawdown is lower, and returns are lower. However, if you bring the volatility up from 4% to 60/40's 11.4%, then you could imagine the return close to doubling from the 6% the strategy gave. If it returned 10-12% then that would be higher than 60/40's 8.2% but with the same volatility.

Google is your friend.

I'll sum it up for you by saying that you essentially take a diversified portfolio of asset classes (stocks, bonds, commodities, real estate) and instead of weighting them 25/25/25/25 or 60/40 or 50/50 or whatever it might be, you weight them according to their volatility. This is because in a standard 60/40 stock/bond portfolio, stocks make up most of the volatility in the portfolio.

Since bonds are typically less volatile than stocks, you would have more bonds in the portfolio. The volatility of the entire portfolio ends up being lower than just a standard 60/40 stock/bond portfolio and so they use leverage to bring the volatility equal to 60/40 or 100% stocks or whatever you want. By then it's supposed to have a higher return than stocks but with equal volatility.

Here's an example by using risk parity for US Total Stock Market fund and US Total Bond Market fund as compared to Vanguard's 60/40 stock/bond fund. It rebalances quarterly and most of the time the weighting is 70-80% stocks and 20-30% bonds. Volatility is much lower than 60/40, drawdown is lower, and returns are lower. However, if you bring the volatility up from 4% to 60/40's 11.4%, then you could imagine the return close to doubling from the 6% the strategy gave. If it returned 10-12% then that would be higher than 60/40's 8.2% but with the same volatility.

https://drive.google.com/file/d/0BzyyTlvGE-T2b1RtMHBWQk5yeDg/view?usp=sharing

[forummm]

http://lmgtfy.com/?q=risk+parity+strategy

[DaKini]

Thank you for googling that for me.
What is your opinion on that? The funds offering it are expensive, but could this be done with a diy approach?
What are the cons?

[691175002]

If you want an academic overview of the concept I'd start with the AQR library:

https://www.aqr.com/library/aqr-publications/understanding-risk-parity
https://www.aqr.com/library/search?keywords=risk+parity

I've never looked too deeply at risk parity because I generally dislike strategies that are based around forecasting volatility/correlation.

I'd colloquially look at risk parity as either MPT taken to its logical extreme, or a highly leveraged play on low-beta.

Leveraged strategies are generally very difficult to implement as an individual investor.  Primary risks to RP strategies would be low-volatility asset classes under-performing, which could become a major problem for fixed income.

[forummm]

Thank you for googling that for me.
What is your opinion on that? The funds offering it are expensive, but could this be done with a diy approach?
What are the cons?

You could certainly DIY it, depending on the approach you wanted to take. I personally don't plan to do anything like it. For my personal spending habits and risk profile, I would prefer to be very heavily in equities. Now, I will diversify those equities, which will moderate the overall volatility somewhat. But not too much. I'm not especially concerned with the paper value of my portfolio at a particular point in time--it's the long run value that I can pull from it that I care about.

[hodedofome]

Check the Investing with Leverage thread, yes this could be done DIY (very easily with ETfReplay) but your desired amount of leverage and vehicle you choose makes a difference. Futures gives the most leverage but you'll need a large account to hold a diversified basket of futures. ETFs or mutual funds would be the best for a small account but have the risk of getting a margin call if you are 2x leveraged and we experience another 2008 scenario.

You could also leverage up a risk parity fund. It would increase your risk obviously but would help you overcome the fees. It wouldn't need to be leveraged that much.

I personally don't do a pure risk parity approach as I don't like leverage on buy and hold strategies. For strategies needing leverage I prefer to have stop losses in place.