Risk Parity

[EdwardjK]

There is an article in today's Wall Street Journal that discusses risk allocation strategies such as "risk budgeting", "risk parity" and "risk control" (WSJ, June 2, 2012, page B7).

Risk budgeting sounds like a new name for asset allocation.  Risk parity is defined as building a portfolio that spreads volatility equally between asset classes.  For example, in a portfolio of stocks and bonds where stocks are much more volatile, the allocation would be something like 90% bonds and 10% stocks.  Both assets would have equally weighted volatility.

Risk control is defined as keeping the volatility of a portfolio constant by selling stocks, for example, as volatility rises and buying stocks as volatility declines.  The concept is for the owner to target an acceptable level of volatility and adjust the portfolio to maintain that level of volatility.

Does anyone have any thoughts on how the returns of the PP would change using the risk parity and risk control concepts?  Or where i can obtain data needed to calculate the estimated returns myself?

Thank you.

[clacy]

The PP really has "risk control" built into it by the fact that it's hedged for all main economic scenarios. 

Risk parity would view and weight accordingly, each of the four asset classes separately.  However the correct way to view the PP is to look at the portfolio as a whole and ignore the performance and volatility of the individual asset classes. 

[hoost]

Offhand, it seems like the whole idea of basing risk off of quantitative data would leave you open to massive distortions in future experiences.  When I say this, it means that just because the data doesn't show something happening in the past doesn't mean it won't happen in the future.  It also doesn't give an indication of the probability of whatever event that would trigger that something happening.  That's a confusing way to say that past performance doesn't predict future results.  Don't count on the past repeating itself.  The value of the permanent portfolio is that it analyses the possible economic scenarios and proposes holding an asset that will profit disproportionately positive relative to the other assets.

The PP is more or less built on risk parity concepts.  The whole idea is that you can't use data to prove you right; you can only use data to prove you wrong.  The whole idea of the permanent portfolio is that you can set it and forget it...aside from the occasional rebalancing.  It seems to have worked well so far, and IMHO the economic reasoning appears to be sound, although I'm sure all of us would be interested in hearing arguments to the contrary.

Regarding relative volatility, I think Clive is probably the best person to answer that kind of a question. 

I may be missing something given that it's 2 am on a Sunday morning , but I hope the above comments help.

[craigr]

My main problem with risk parity discussions so far is that it is based on past volatility data largely that does not take into account why the assets were volatile. In essence, it is the asset class correlation portfolio model but weighted against past volatility to temper things a bit.

But the positive from the risk parity publicity is that it brings to light that strategies like the Permanent Portfolio that seemingly hold "too little" in assets like stocks actually are safer and can produce returns just as good. So there is nibbling around the edges, but until they wrap the economic theory inside it I'm not sure it's a complete solution.