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.