What Is an All Weather Portfolio?
Lesson Q: Applying Risk Parity
The All Weather Portfolio (AWP, hereafter) was created by Ray Dalio’s hedge fund Bridgewater Associates to
“perform well across all environments, be it a devaluation or something completely different.”
It was researched and developed by Dalio, Bob Prince, Greg Jensen, and Dan Bernstein. It attempts to take guessing and predicting the future out of investment. Instead it begins with the basic principle that
“When investing over the long run, all you can have confidence in is that (1) holding assets should provide a return above cash, and (2) asset volatility will be largely driven by how economic conditions unfold relative to current expectations (as well as how these expectations change). That’s it.”
The key to seeing how this basic principle is put into practice requires understanding risk parity.
What Is Risk Parity? How Does it Work?
As you might have guessed, risk parity assessment methods rely on complex calculative processes that can draw on a robust selection of data. Hedge funds, like Dalio’s Bridgewater, use risk parity methods to garner returns in even the worst of market conditions.
Risk parity improves on a common human method of conceptualization. Humans tend to relate to general ideas first and then pare down their conceptual analysis to get a better understanding. Of course, there are times when people want to be involved in something, yet don’t want to dive deeper into the details of that “something”.
Take a weekend warrior who loves to be out on the water windsurfing versus the committed windsurfing fanatic who has a nuanced relationship to the wind and tides as they manifest in various localities and conditions. The weekend warrior probably has the basic equipment set up that is good for optimal conditions. The fanatic, on the other hand, has a wide range of equipment that is built for specific conditions. Though the use of such equipment enables the fanatic to sail in almost any conditions (except lack of wind!), it costs much more compared to what the weekend warrior has.
In other words, getting more conceptually oriented about the activity of windsurfing has provided the fanatic more utility, but only with more investment.
60/40 Portfolio = Weekend Warrior
Risk parity is essentially a method of dialing in on the details of the risks involved in individual assets in order to determine one’s level of investment. So instead of a “weekend warrior” approach where you simply buy a typical portfolio of assets — e.g. 60% in equities and 40% in bonds — you can base your investment on the risk each asset presents.
The 60/40 portfolio was designed to present an investor with a well-balanced set of assets where 60% has the potential to present higher returns, while the 40% in bonds is designed for longer term investment. It is based on a general idea of type — equities vs. bonds. And it might involve further delineations of types of equities (e.g. tech, growth, blue chip) and bonds (e.g. mid-term to long-term bonds).
Risk parity does not jettison this way of looking at assets, but it does not consider their type to give an accurate representation of their risk potential. Instead, risk parity methods look at the risk of each asset to see if it fits with the investor’s appetite or tolerance for risk. It can therefore more adeptly take into consideration the larger macroeconomic environment with respect to how its risk might potentially manifest.
The Nuts & Bolts of AWP
When applying risk parity methods, the AWP breaks down asset allocation according to economic environment (ibid.):
“(1) inflation rises, (2) inflation falls, (3) growth rises, and (4) growth falls relative to expectations.”
The goal is to outperform market benchmarks (i.e. seeking alpha). Let’s break down each component briefly.
Rising Inflation
The US dollar weakens, and inflation-linked bonds (ILBs) can help protect investors against unexpected inflation “by contractually linking the bonds’ principal and interest payments to a nationally recognized inflation measure such as the Retail Price Index (RPI) in the UK, the European Harmonised Index of Consumer Prices (HICP) ex-tobacco in Europe, and the Consumer Price Index (CPI) in the U.S.” As inflation increases, the bond’s face or par value increases.
An example of ILBs is TIPS (Treasury Inflation-Protected Securities), which Bridgewater Associates helped to create!
Specific commodities can also do well in inflationary conditions. Gold and other precious metals often rise in value as people invest in them to hedge against the drop in the value of cash.
Emerging market credits refer to investments in nations whose markets are not fully developed. A weak US dollar means that US exports cost less, creating an inflow into such markets. As long as a rise in inflation is not accompanied by an increase in interest rates, EMs benefit from greater investment power and a low cost of borrowing.
Falling Inflation
Assuming that as inflation falls, interest rates also fall: equities benefit when the cost of borrowing, and hence investment in growth, costs less.
Nominal bonds offer a fixed payment that takes into account the rate of inflation. So as inflation falls, someone who has taken out a nominal bond will benefit from the difference between the nominal rate and the current “real” rate (which is typically falling).
Rising Growth
Those assets which benefit most from growth are those whose growth stands the most to gain. In other words, the more cash in to fund a project, the better that asset will perform.
With Corporate and EM credit, the idea is that the cost of borrowing is still low. One can inject cash into businesses to expand and emerging markets to build.
Equities and commodities benefit not only from lower borrowing costs but also an increase in demand as people who are earning more start to use more (or seek more utility) and invest more.
Falling Growth
Nominal bonds and other debt instruments that guarantee a fixed rate of payment do well when an economy is shrinking since typically interest rates will fall in order to try and boost the economy. As interest rates fall, bond prices rise.
Nominal bonds can potentially benefit more than “the average bond” if the economy is contracting and inflation does not rise (i.e. stagflation). This is assuming the nominal bond was written according to an expected rate of inflation that is greater than the real rate of inflation during contraction, which is typically lower due to a fall in employment and demand.
While ILBs protect against an unexpected rise in inflation, their purchase price is calculated based on expected inflation rates — i.e., expected inflation is “priced into” the cost of the bond. Buying a ILB during a contracting economy would mean “pricing in” low inflation rates. They would be less expensive and then afford protection as the economy grows and inflation increases.
Note that the recent downturn of 2022 is an exception. High interest rates meant that bond yields increased while their price correspondingly fell. The extremely high interest rates in 2022 meant that bond prices have fallen so much that their decline has outpaced higher returns against inflation.
How This Can Be Applied
It’s important to note that the AWP is not meant to optimize returns in comparison to every other form of investment, but rather to provide a portfolio that will do well in any given economic environment. Other portfolios may do better, but those portfolios will be suited to and leveraged against a specific environment. As one pundit describes it, the AWP is “a ‘sleep well at night’ portfolio with smaller drawdowns and good risk-adjusted returns.”
This article is a part of the Crypto Industry Essentials educational program presented by 1.2 Labs (formerly The Art of the Bubble).
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his 1.2 Labs education series on cryptocurrencies.
If you found this helpful, Subscribe to 1.2 Lab’s free newsletter.
Join us on Discord for live chat and daily updates.
This content is provided for educational and entertainment purposes only. You should expect no financial returns one way or another based on the statements contained herein.Robin Technologies and Analytics LLC is the firm that distributes The Art of The Bubble products. The firm does not provide individually tailored investment advice and does not take a subscriber’s or anyone’s personal circumstances into consideration when discussing investments; nor is Robin Technologies and Analytics LLC registered as an investment adviser or broker-dealer in any jurisdiction.
