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How to Use the Global Risk Parity Model Effectively

April 2021 marks the 1st anniversary for our Global Risk Parity Model!

So in today's article we're going to honour our model by explaining more about what it is and what place it has within your portfolio.

What is the Global Risk Parity Principle?

What mix of assets has the best chance of delivering good returns over time through all economic environments? - Ray Dalio & Bob Prince, 1996

The “risk parity” concept was popularized by Ray Dalio’s Bridgewater Associates with the creation of the All Weather asset allocation strategy in 1996. “All Weather” is a term used to designate a strategy that should perform reasonably well during both favorable and unfavorable economic and market conditions.

A risk parity portfolio seeks to achieve an equal balance between the risk associated with each asset class or portfolio component. In that way, lower risk asset classes will generally have higher notional allocations than higher risk asset classes.

Source: SeekingAlpha

Dalio and Prince started to answer the question by returning to the principles behind asset pricing:

  • Asset classes outperform cash over time: investors require a higher compensation in order to put their money somewhere that is not their own bank account, because there is risk involved.

  • Asset classes are sensible to, and discount, future economic scenarios: the price of any asset is the market's best guess about the current value of future discounted cash flows. As the macro environment and expectations change, prices change.

As such, the 2 major drivers of returns should logically be the volume of economic activity (growth) and the pricing of that activity (inflation).

Where we Differ from Traditional Risk Parity

Traditional risk parity portfolios are made up of 4 distinct "sub-portfolios" that include asset classes which should thrive in the various economic environments, so losses in one area should be offset by gains in other areas.

What we do instead is a bit different.

In agreement with the risk parity principles, we maintain a broad diversification and we take into consideration the volatility of an asset when calculating the weight it should have in the portfolio.

But we also go a step further and look to invest only when recent momentum in global equities is positive, and recent momentum in single assets is positive.

As such, the Global Risk Parity Model adds a momentum component and strong drawdown protection because the portfolio will switch to a cash allocation when conditions are unfavourable.

This becomes evident if you view the drawdowns since we deployed the model live: a MaxDD of 6.8% in September 2020. Even during the Jan-Mar 2020 Coronavirus crisis, the model didn't surpass a 7% MaxDD.

Compare that with the MaxDD of the S&P 500 in 2020: 33.79%!

The low drawdowns, together with consistent performance, allow our GRP model to maintain a consistently robust Sharpe Ratio which has a long-term average of 2.0, and is running at 2.5 currently.

Our performance since April 2020 is as follows:

GRP = Diversification + Momentum + Downside Protection

Maintaining contained drawdowns allows for a much "calmer" ride because, as traders know well, it's much harder and more painful to work your way out of a drawdown than it is to work through fresh equity highs.

In the long-run, the continuous compounding effect that helps your investments grow over time is heavily impacted by drawdowns. With our GRP, we are attempting to limit the time your money spends "working out of drawdowns" and maximise the time your money spends "climbing to fresh highs".

To illustrate this principle, here is a simple equation you can use in order to ensure you are within your risk tolerance boundaries on any kind of investment, or in total with all your investments:

Maximum Risk Tolerance Check:

[(Total Risk Exposure * 2.5 * MaxDD%)/Monthly Net Income] < 12

or, reorganising the terms,

Total Risk Exposure < (12*Monthly Net Income)/(2.5*MaxDD%)

This formula tells you how many months you will need to work in order to recover a statistically improbable (but possible!) drawdown, given the history of the investment at hand. I suggest, in a very conservative fashion, that you never risk more than 1 years' worth of income on any single investment.

For families with lower incomes, perhaps it's better if their total risk exposure on all investments is limited to 1 years' worth of income.

For example, if you have €100.000 invested in the GRP model and your combined family net income is €3000/month, have you invested too much, too little, or just enough?

(12*3000)/(2.5*0.068) = €211.765

This means you can lose €36.000 on a €211.765 portfolio, or €17.000 on your €100.000 allocation.

So in reality, you still have another 111.000 Euros you could invest, given the MaxDD parameters of the GRP up until this point in time. We are multiplying the system's MaxDD by 2.5 as an industry standard.

This little formula allows you to understand why traders in particular are so concerned about maintaining very low drawdowns: low drawdowns allows for much larger risk allocations to their trading models. For example, compare the Risk Exposure Limit for the GRP (above) with the hypothetical Risk Exposure Limit for the SP500 over the past 5 years:

(12*3000)/(2.5*0.34) = € 42.353, which is a much lower allocation than before.

As you can see, the risk allocation is all about the drawdowns. Higher drawdowns = higher risk = lower investment allocation.

Allocations for April 2021

As an example, here are the ETFs that our model is invested in for April 2021:

Using the Right Tool for the Right Job

One last thing to consider: whether you are using the right instrument for the right job.

I frequently speak with traders that are trying to use their trading to do what their investment portfolio should be doing...which is kind of illogical.

Your investment portfolio should be aimed at generating long-term capital appreciation with minimal downside risk (and this is what we designed the GRP to do). Investment portfolios are meant to put your money to work while you sleep, growing as steadily as possible in order to reach the critical mass you will need during retirement (which is approximately 25x your annual expenses).

So the idea should be to use your work income and your trading income to gradually enlarge your investment portfolio, adding during declines and scaling out a tad at new equity highs, so you can promptly reinvest during the next dip.

Instead, I find that people who are attracted to trading generally think they should trade with their retirement funds in order to grow them quicker than regular investment vehicles can.

Of course, this logic is flawed for various reasons:

  • trading is a job, which requires work and dedication. It is wiser to setup something that will allow you to grow your savings while you sleep...because at some point in life you will want to sleep more and work less;

  • trading is more difficult than investing for the long-term;

  • trading implies more risk and hence should be done with a smaller amount of funds;

  • trading implies concentrated positions whereas investing is more about diversification.

I'm sure there are more differences than I can think of right now, but you get the point: investing should be a "lazy" and efficient approach to long-term capital appreciation and income generation. Instead, trading is an active endeavour which requires top tier skills.

Use the right tool for the right job:

  • asset allocation models (like the GRP): conservative but consistent long-term growth with strong downside protection;

  • options on stocks (fourthcoming): conservative but consistent income generation;

  • active market timing/trading: a job that can produce strong returns but also requires time, dedication and skill.

I'm here to help you reach your objectives from all points of view (and I'm working towards becoming a Licenced Financial Advisor as well, in order to offer personal advice). But I'd encourage you to look beyond trading, and structure a portfolio that can help you reach important long-term goals which will be essential for your retirement.

The Global Risk Parity model is one of these tools that can help you do this - and at the cost of 1 espresso/day!



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