Bridgewater’s Risk Parity Strategy: A Model for Navigating (All) Capital Markets by Balint Anton Francisc
As Thomas Barrack, founder of Colony Capital, stated very accurately in his keynote speech to the Principal Investment Conference in 2008, great investors understand the fabric of the culture they are in. In other words, they are able to make sense of what people need and want. In addition to this ‘magic’ quality of sensing what society consumes you need to know where to look and how to search for that information. The problem is that the information you have is not the information you want; the information you want is not the information you need and the information you need is not the information you can get because information you can get everyone already has it.
Moreover, not only it can be difficult to get the information you need in order to assess the quality of a business or a franchise but you have to account for a factor that breaks most investors: randomness or chance or surprise. Ray Dalio, the founder of Bridgewater Associates, explains in a document published on Bridgewater’s website that surprises, such as President Nixon’s 1971 decision to suspend temporarily the convertibility of the dollar into gold, changed his perception of how markets and economies work. For example, Ray thought that President Nixon’s decision was going to send the markets into the red territory – what happened was the total opposite: the Dow Jones Industrial Average rose almost 4%.
This situation made Ray think about his own perception of his own experiences and as he started questioning what impact these unforeseeable events might have on the economy, he realized that an economy can be understood you break it down to fundamental components and study the relationship between these pieces over time. The All Weather Fund has been built upon this line of thought and was the product of the question Ray and his colleagues explored into detail: ‘What kind of investment portfolio would you hold that would perform well across all environments, be it devaluation or something completely different?’
All Weather employs a portfolio building strategy called Risk Parity. This strategy has attracted much controversy. In fact, it has attracted so much commentary from the financial world that in September 2015, Bridgewater has published a research paper on what Risk Parity is and how it works. In this article, we will look in brief at this strategy.
The strategy is the result of Ray’s realization that it is difficult or nearly impossible to discern how people make decisions and therefore, to distinguish who will make money and who will lose it and that strategic asset allocation was the most important decision. Another building block was the common feature the thousands of investment products share between them: the ‘moving parts’ of their return: the return of any product is a ‘function of a) the return on cash, b) the return of a market (beta) above the cash rate and c) the ‘tilts’ or manager stock selection (alpha)’.
The meaning of risk parity is adjusting for expected risks and returns of assets to make them more comparable and to get a better understanding of how they behave in different market conditions. The purpose for doing this exercise is to build a diversified portfolio that outperforms the market regardless of the economic downturns of prosperity. An important concept that the All Weather Fund is employing when using risk parity is the notion of risk – Bridgewater regards risk as both volatility and the risk of their assumptions regarding market conditions to be wrong or bad. Both forms of risk are mitigated by diversification.
Most of us are not strangers to the idea of diversifying our portfolios into stocks and bonds – indeed we know that stocks (historically) tend to produce returns higher than bonds (because we also take more risk when we invest in equities). However, the real mastery is to know how much to put into stocks and how much into bonds, when to chance the positions and what assets to sell or buy during the changing (transition) period. As Bridgewater suggests allocating 50%-50% is not a good strategy because you needs bonds and stocks to have a comparable impact on your portfolio, i.e. diversification. What diversification does is to improve the ratio of return to risk.
Risk parity is about the trade-off between risk and return and gearing your portfolio in a way that reduces risk and supports the expected return you want to achieve. For example, because equities are much riskier than bonds and are also the main drivers of return you can use bonds to reduce the risk from equities and keep the rate of return unchanged.
Here is how I think about this strategy. Imagine your portfolio to be a machine with its performance being drive by the assets you hold in it. You, as a careful driver (and conservative investor) monitor this performance with charts. Chart 1 is allocated to stocks and Chart 2 is representative of the bonds. As time passes on your charts will go up and down based on the risk-return ratio. Ideally you would like them to be up as much as you can. However, due to economic conditions and market vicissitudes this cannot be achieved. What you want to do then is to manage the allocation of capital into these two charts accordingly to what happens in the economy so you can profit from it: if Chart 1 (equities), say, goes up, meaning that they outperform the bonds, then you will want to regulate the risk-return balance to the level you are comfortable with.
This article aimed to provide you with a brief overview of what risk parity is: a trade-off between risk and return with the purpose of reducing risk but not hurting the return. This can be done by understanding the financial dynamic (market behaviour) of the assets you hold and how they impact your portfolio. Additionally, an on-going understanding of the forces that move the economy: the long and short debt cycles and productivity line, will help you make decisions of when and how to change the amount of capital allocated in bonds and stocks.