This blog will make a lot more sense if you are able to capture and read Edward Qian’s article, Risk Parity Allocation. This blog post is a brief description of how risk is calculated. This not for the mathematically squeamish, but the concept is not difficult if one can get past one step in the logic. I should mention that I am somewhat skeptical of Risk Parity as a portfolio construction model and the reason is that this model worked very well so long as interest rates were dropping and bonds continued to appreciate in value as a result. That trend is not going to continue so it is unlikely Risk Parity will have a future to match past performance. Nevertheless, it is an interesting concept and one worth examining. Here at ITA we are risk aware and use several triggers to prevent huge losses as a result of bear markets.
A standard portfolio breakdown between stocks and bonds is 60%/40%. Most investors will argue this is a well-diversified and somewhat conservative portfolio. It is certainly more conservative than most of the ITA Wealth Management portfolios. But is the 60/40 mix a conservative portfolio? I just checked my data sources and found that the standard deviation (SD) of stocks over the past five years is +/-16% and the SD for bonds is +/-3%. However, when one takes variance into account, we must square each number so the 16% has a variance of 256 and for bonds it is 3 x 3 or 9. In terms of variance, stocks are (256/9 = 28.4) or 28 when rounded) times riskier than bonds. That is a huge difference. Even if stocks carried a standard deviation of 15% and bonds 5%, in terms of variance, stocks are nine times riskier than bonds.
To borrow an analogy from Edward Qian, if we go back to the 60/40 stock to bond split, we have six stock eggs and four bond eggs. To calculate the true risk of stocks we find we have 172 (28 x 6 + 4) eggs in total. One hundred sixty eight (28 x 6 = 168) out of 172 is approximately 98%. Very close to 100% of the 60/40 portfolio of risk is carried by the stock portion of the portfolio.
It is important to think how a portfolio is put together and ITA readers would do well to pay attention. The 70/30 or even 80/20 mix is fine when stocks are in the ascendency. But let another bear market strike, and the high stock to bond portfolios are in for another two to three sigma shakedown. That is exactly what we want to avoid. If we were to build a conservative portfolio around the concept of Risk Parity, we would need a 10/90 stock/bond ratio and to do so would cripple the portfolio return. This is why we use SHY as a cutoff ETF and also factor in the price of the ETF with respect to its 195-Day EMA.