Risk Parity. Alex Shahidi
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was a memorable hour that culminated in my asking a simple question: If this is so obvious, then why is this approach so different from the conventional portfolio? Ray said that he had grappled with that very question for years and finally concluded that it was because of a lack of smart, independent thinkers. We are educated in school to read and regurgitate what we learned on exams and papers. Those who master this process tend to excel in school and earn highly coveted job offers. At work, they are generally trained to follow the lead of others before them, and the process repeats itself. Rarely are we encouraged to challenge convention and discern the truth by investigating the core issues ourselves. Inertia and peer risk can also play material roles in prolonging the status quo. Both can prevent adoption of new approaches even when there's agreement that it is better. The pull to follow others and the risk of being different and looking wrong can be powerful forces that require both independent thinking as well as high conviction to overcome.
To reach the All Weather framework he had to challenge the assumptions he had been taught at Harvard Business School and through broadly accepted investment tenets. He had to think independently to, in effect, reinvent the proverbial wheel. One of Ray's gifts is his intuitive drive to avoid blindly accepting traditional perspectives and to start from the most basic level to uncover his own conclusions. He described it as going from assumption A to assumption B and so on until you reach the conclusion. Most people don't go back to A, they start at E since it is widely viewed as the truth. If you start at E, then you end up in the same place as everyone else, but if you start at A you end up where he did.
I learned from Ray not to accept investment assumptions on their face without doing the independent work to determine if I arrive at the same point. Therefore, I took what he taught me and set out to figure it out on my own. This sparked a multiyear research project and development of a 10,000‐page Excel spreadsheet as I studied 100 years of financial market data. Of course, I ended up in the exact same place as Ray and eventually published my findings in my first book, Balanced Asset Allocation: How to Profit in Any Economic Climate, which was published by Wiley in 2014. Ray and Bridgewater were strongly supportive of the project and instrumental in providing me with the required data to back my findings.
Damien called me after my first meeting with Ray to let me know that Ray enjoyed our encounter and hoped that I would join Bridgewater. I managed to flip the discussion by explaining to Damien why I loved my career and my position of helping my clients, and I would never consider a change. That led to an ongoing dialogue about possibly working together at some point in the future. Over time, we realized that we were completely aligned in our mission to strive to continually improve client portfolios and our belief about how an ideal business should be managed. Six years later Damien got married and decided it was time to move back to California to be closer to his family and to raise a family of his own. He left Bridgewater in 2013 after a successful nine‐year career and took 10 months off to travel to 23 countries on an extended honeymoon. Damien joined me when I departed Merrill Lynch after 15 years, and we launched our own firm, Advanced Research Investment Solutions (ARIS), in 2014. This marked another major inflection point in my career.
ARIS managed over $12 billion in client assets for many years and was consistently ranked among the top advisory firms in the country by Barron’s.1 We implemented the investment framework, which was described in my first book, across our client portfolios. Five years after founding ARIS, we created the Advanced Research Risk Parity Index as a proxy for the investment approach. This allowed us to back test and publish the results over a long period of time through shifting economic environments.
This brings us to the present. The reason I wrote this book is to describe the thought process that has led our journey to risk parity. My goal is to memorialize our learning over the past 15 years in simple‐to‐understand, nontechnical language that anyone who is interested in investing can absorb. I begin with bigger‐picture topics and work my way down to the details. For those who enjoyed my first book, this may essentially be viewed as a second, more refined edition that is tailored for the specific risk parity index that we created. I strive to present this information to you so you can objectively decide for yourself whether the framework is sound.
The book is divided into the following chapters:
Chapter 1 describes the conceptual framework for risk parity. I will explain what it means to be well balanced and why the conventional portfolio is surprisingly poorly balanced.
Chapter 2 gets into the two required steps to build balance: (1) selecting the right asset classes, and (2) structuring each to have similar returns.
Chapters 3–7 dive into the major asset classes used in our risk parity model. I explain what they are, how they perform in different economic environments, and their role in a balanced mix of assets.
Chapter 8 lays out the details of our risk parity portfolio, including the desired weighting to each asset class and, most important, the rationale for the specific allocation.The Risk Parity Portfolio25% global equities25% commodities (15% commodity producer equities, 10% gold)35% long‐term Treasuries35% long‐term TIPS
Chapter 9 provides a long‐term historical return series to show how the risk parity portfolio would have performed through varying market environments.
Chapter 10 covers the timeliness of the risk parity approach. Given the wide range of potential economic outcomes looking forward, today appears to be a prudent time for investors to maintain strong balance.
Chapter 11 gets into the “rebalancing boost,” which refers to the increase in returns that comes from a repeated process of buying low and selling high.
Chapter 12 covers implementation strategies to put the concepts into practice.
Chapter 13 points out the unique environments during which the risk parity portfolio may be expected to perform poorly. I think of this chapter as a “Break in Case of Emergency” warning. It serves as a reminder to adopters of risk parity to read this section if tempted to abandon the strategy.
Chapter 14 summarizes my responses to the most commonly raised questions and objections I've heard about risk parity over the past 15 years.
Chapter 15 offers some concluding remarks.
NOTE
1 1 The Barron's Top RIA Firms rankings are based on data provided by over 4,000 of the nation's most productive advisors. Factors used in the rankings include: assets under management, revenue produced for the firm, regulatory record, technology spending, staff diversity, succession planning, quality of practice, and philanthropic work. Investment performance isn't an explicit component because not all advisors have audited results and because performance figures often are influenced more by clients' risk tolerance than by an advisor's investment‐picking abilities. Barron's is a registered trademark of Dow Jones & Company, L.P. All rights reserved.
CHAPTER ONE
