Most people – including most professional advisors -- have long followed essentially the same handful of common investment strategies. Invest in equities when the market looks strong, ride the wave as long as they can, make an educated guess about when things are going to turn, shift to something a bit more conservative, and hope they timed it all approximately right.

In a nutshell, it means taking on more short-term risk in hopes of greater long-term returns. And, because markets historically go up over time, this basic strategy has generally produced decent results over time. Of course, that “long-term” part is the key because with anything less than a decade or so to work with you need to hope your timing works out. Unfortunately, statistically, it rarely does. There is a wealth of information out there showing that timing the market is a fool’s errand. Even the smartest, most knowledgeable investors fail to beat the market if they are off by even a month getting in or out.

So, where does that leave the more savvy investor, the one who isn’t interested in playing guessing games with a complex global economy? Well, one approach that has proven far more successful – from both risk and return perspectives – is a strategy called “Risk Parity.” Developed through decades of study, implementation and monitoring, this simple, logical approach is designed to maximize the return/risk ratio in any economic environment. By striving to remove unpredictable economic fluctuations from the equation it can successfully provide quality returns with just a fraction of the volatility.

Where did it begin?

Risk Parity is a modern evolution of something called the“All Weather strategy,” a method developed by Ray Dalio of Bridgewater Associates way back in the 1990s. The cornerstone of the All-Weather concept is to use a balanced approach to ensure that all the unpredictable short-term risks of investing cancel each other out over time. This is based on the idea that different asset classes react predictably to economic factors, so by determining and implementing contradicting measures the overall impact of economic changes can be minimized. Essentially, it is choosing an asset allocation that includes a variety of components – equities, bonds, cash – each of which responded positively to different economic stimuli, the main four of which are as follows:

1.    Inflation increases

2.    Inflation decreases

3.    Growth increases

4.    Growth decreases

It is a passive approach that does not require the investor to predict future events. The idea is to design a portfolio with a long-term asset allocation that performs regardless of specific outside influences.

Risk Parity

This method starts with the All-Weather strategy and refines it to create an even greater return/risk ratio. It follows the theory that all correlation and volatility assumptions are unpredictable and attempts to achieve a “reliable balance” that will outperform traditional asset allocation. For example, we know that stock prices increase when earnings increase and that bond prices increase when interest rates decrease. However, both stocks and bonds increase when inflation decreases, and when more than one of these events takes place it is difficult, if not impossible, to decide which will win out. Therefore, Risk Parity seeks to ignore correlation and focus on the relationship of each asset to the economic factor that most significantly impacts it.

The entire concept is based on two universal truths:

1.    Assets outperform cash over time because of the risk premium attached.

2.    Asset prices incorporate future economic expectations.

Working from that starting point, the goal is to identify the risk premium as accurately as possible and minimize the risk of any unexpected changes. Then, by spreading assets across four different classes that each reacts positively to a different economic stimulus, we can build a portfolio of assets that reliably offset each other from a risk perspective. Over time, this type of portfolio has proven to produce 2-3 times the return/risk ratio of a traditional portfolio. Also, because we are targeting the ratio, not the specific return, it can be adjusted to match each investor’s situation and risk tolerance. The portfolio can be designed to achieve greater returns with equal risk, or simply match the returns of a traditional portfolio with far less volatility or anything in between.

Conclusion

Both statistically and conceptually, balance is a more effective strategy than basic asset allocation. Instead of wildly guessing what global markets will do next and vainly attempting to match a specific asset-allocation to these highly unpredictable events, it is far more effective to implement a solid, balanced Risk Parity portfolio that will produce more efficient returns over both the short and long-term.

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