July 6, 2012: Risk Parity

Most investors acknowledge that bonds reduce the risk of an equity centric portfolio. Smart investors realize that the real risk reduction comes from bonds offering contra movements, rather than simply watering down the portfolio. When interest rates drop because of economic weakness, the price of low credit risk bonds often rises as equities fall.

 However, many investors still think of bonds as just adding water to the whiskey. They see bonds as the “safe” part of their portfolio and equities as the “risk” part of their portfolio. This logic produces a less than optimal portfolio because investors are not maximizing the contra movements offered by some bonds.

 If we look at a 50/50 portfolio of the Total Stock Market (TSM) and Total Bond Market (TBM), we see a terribly unbalanced portfolio. The dollar amounts are equal, but the risks are not; the portfolio is dominated by equities. Over the past 3 years, equities have had a volatility of 19.6% where as the TBM has had 3.7%. To run a truly balanced portfolio of these two instruments, one would need to hold roughly 15% TSM and 85% TBM; this is required to have the movements balance each other out.

 I think the Permanent Portfolio offers a nice solution with the use of 30 year Treasurys. When we compare the last three years of returns for TLT (a decent proxy for the 30 year), with VTI (proxy for TSM) we find the volatilities are nearly on par. VTI has had a volatility of 19.6% whereas TLT had a volatility of 17.4%. Rather than adding water to our whiskey, we are making ourselves a pretty nice cocktail. By utilizing bonds that have similar volatility to stocks, we are ensuring that their contra movements are enough to offset any losses stemming from equities.

 We can see the effect in portfolio volatilities: 50/50 TSM and TBM had a volatility of 10.2% whereas substituting 30 year Treasurys in for TBM brought the volatility down to 8.6%. Ironically, by increasing the duration risk we have decreased our portfolio risk. Gold is the final major mover in the Permanent Portfolio; funnily enough it has a volatility of 18.3%. So stocks, 30 years, and gold, all are at risk parity when held in equal dollar amounts! The equal split between the asset classes in the PP is no coincidence. Unfortunately, we don’t have a super volatile cash option. Cash is mainly used in the PP as a hedge against rising interest rates, and if a more volatile yet still reliable hedge presented itself I would be tempted.

 I hope exploring volatilities has helped clarify some of the PP positions. I think it is fascinating that risk parity portfolios just started to take off in the mid 90s, but Harry Browne devised the PP in the early 80s. It was a portfolio ahead of its time intellectually, and it still works years after his death.

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