Risk Parity Funds In Current Environment
Risk parity approach was made famous by Bridgewater (and its founder Ray Dalio). The approach was dubbed as ‘all weather’ as it was intended to work all the time regardless of market conditions.
Unfortunately, the strategy took a hit last year. In this newsletter, we review some risk parity funds in the market and discuss the strategy going forward.
The risk parity strategy
The risk parity strategy in its original form is to allocate assets evenly based on their risk. In a simple fashion, the risk of an asset class such as stocks or US stocks is defined as their volatility. For example, let’s say US stocks, represented by VTI, has volatility of 17.7% (in the last 10 years, annualized standard deviation) and US bonds, represented by BND, has volatility of 4.3% in the last 10 years, a risk parity allocation for a portfolio of consisting of only US stocks and bonds would demand the stock/bond allocation ratio = 4.3/17.7. From this relationship, one can derive the US stock allocation =4.3/(17.7+4.3)=19.5% and the bond allocation = 80.5% or 1:4 ratio. In this way, both the stocks and bonds contribute about the same ‘risk’ or ‘volatility’ to the overall portfolio.
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