Risk Parity - Finance lesson 1
Warning Long Macro Post ahead!
The aim of this post is to open the discussion on risk parity and add insight into why some of the largest macro funds in the world use the strategy of risk parity.
... It is basically an asset allocation concept.
-> At what point do we have our portfolio 100% in these really safe securities (safest of all is inflation protected securities... which are bonds issued by sovereign entity without inflation return) Yields are very small.. sub 1% usually.
-> Then you have normal bonds, these can be any kinds of bonds. They don't have to be treasuries they can be corporate bonds.
-> And then you have mixed portfolio, which is maybe 60% stocks and 40% bonds...
-> Or perhaps a really risky portfolio with 100% stocks
-> Or EVEN riskier with 100% Emerging Market Equities.
+++++ The question is what kind of returns do we expect? +++++
One of the ways people employ Risk Parity is a re-balancing concept;
The aim of this post is to open the discussion on risk parity and add insight into why some of the largest macro funds in the world use the strategy of risk parity.
... It is basically an asset allocation concept.
-> At what point do we have our portfolio 100% in these really safe securities (safest of all is inflation protected securities... which are bonds issued by sovereign entity without inflation return) Yields are very small.. sub 1% usually.
-> Then you have normal bonds, these can be any kinds of bonds. They don't have to be treasuries they can be corporate bonds.
-> And then you have mixed portfolio, which is maybe 60% stocks and 40% bonds...
-> Or perhaps a really risky portfolio with 100% stocks
-> Or EVEN riskier with 100% Emerging Market Equities.
+++++ The question is what kind of returns do we expect? +++++
One of the ways people employ Risk Parity is a re-balancing concept;
Lets assume its Year 1 with EP (Equity Perfomance), BP (Bond Performance) and EE (Equity Exposure) and BE (Bond Exposure) and the ideal mix is 60% EE with 40% BE
Year 0 your fund was obviously not around. In Y1 we can see that equity performance has dropped. It's a fallacy, though you may expect that equity performance is likely to go up in Y2, so instead of the 60/40 ideal mix in year 1 you might actually have a 70/30 mix in year 2 because you have gotten the juice out of the bonds.
=> Lets say in Y1 Equities drop again and Bonds also drop 5%... not a great year btw as you lost 7% on equities and 1.5% on bonds so down 8.5% on the year.
=> Y2r we expect equities to do even better so we up to 80% exposure on equities, then there is big rebound in markets and equities go up with a great year you return 16%. You think you are now over exposure compared to your 60/40 so you will move down in Y3 perhaps to 50/50
=> Your hope in Y3 is that you are trading off effective return with risk and this is one way people implement it.
Implementation of risk parity is often quite different from maybe what I have describe but this is one way to think about it.