Portfolio Update – December 2020 – What is Dynamic Risk Allocation?

Portfolio Update – December 2020 – What is Dynamic Risk Allocation?

Contents of this month’s post include:

  • How your risk parity portfolio can benefit from Dynamic Risk Allocation
  • Portfolio changes: Scaled down Bitcoin, switched part of Long-Term Government Bonds currency exposure from USD to EUR
  • Monthly Update for December 2020
  • Book tip: Risk Parity Fundamentals by Edward Qian (link at the bottom of the article)
  • In case you missed it: My latest Insight article about How VIX ETFs can improve portfolio performance and stability in volatile environments

It is official, we have survived 2020!

Hopefully, 2021 will be a much better year, but only because the calendar now shows “2021” instead of “2020”, it does not automatically mean that the situation has changed. We still face many of the same challenge as we did only a week ago.

On that positive note, I am glad to have you back for a new year with this blog about the All Seasons Portfolio and how retail investors can get access to the benefits from risk parity strategies. I have now been writing this blog for 2 years, and it has been an incredible experience. I have learnt a lot along the way, and I hope you have too! But mostly, I enjoy all the discussions with you readers, both in the comment section and bilaterally through different channels. I think discussions are an even better tool for learning and improving, as triangulation of strategies and analyses are important.

I look forward for a new year with this blog, and if you have any ideas of how to make it even better, I am always open for your input! My plan is to continue with the monthly updates, and mix in Insights post about various relevant topics. I will also try to find the time to create a better library over the key components of risk parity investing as different pages to the blog, to provide a better learning experience. I’ll try to find the time to do that as soon as possible.

In other news, I have barely left the apartment in December and am getting a bit restless. It is good though that we have recently moved in so we have a fresh view to take in. Also, there are still furnishing jobs to do, meaning that I have been able to spend some days painting walls, putting up wallpaper, and assembling furniture. Let’s hang in there for a little while longer though – hopefully the vaccine rollout will be successful, and at least soon it is spring again with more light and warmth.

As for my portfolio, it looks more or less the same since the last update. The performance in December was positive, and I have only done a few small rebalancing trades. More on that later in this article.

First though, we will dig into a summary on Dynamic Risk Allocation, meaning how you can make allocation shifts in a fairly static portfolio to increase risk-adjusted return during environments that will be disadvantageous for certain assets.

Thanks again for your continuing to take the time to follow this blog. It is fantastic to see that there are more investors out there who knows that it is incredibly risky to only be invested on the stock market. Diversification is important, and it is vital to prepare for all the twists and turns of a complex modern financial market. But let us now get started with the last monthly update of 2020.

How can you benefit from Dynamic Risk Allocation?

To understand dynamic risk allocation, let us first remind ourselves what risk parity investing is all about, for example when using the All Seasons Portfolio strategy.

The All Seasons Portfolio strategy is a simplified risk parity portfolio that is suitable for retail investors to apply when investing. Commonly, risk parity funds use around 15 different asset classes with low correlation to achieve a portfolio with balanced risk. Such portfolios are cumbersome to replicate without significant wealth, why the All Seasons Portfolio achieves similar benefits of risk parity, but only with 4-5 asset classes.

These uncorrelated assets will perform differently in different market environments (changes in expectations of growth and inflation) and all have different degrees volatility. For example, stocks are more volatile than bonds, and commodities are more volatile than stocks.

With the different degrees of volatility in mind, you would fashion a balanced portfolio of the 4-5 assets. Each asset class’ weight in the portfolio would be determined by its volatility and bias for economic environments. With a found balance, the portfolio could then be left untouched for long periods of time, with only the occasional rebalancing (for example annual or quarterly) to keep the asset class splits around their aimed percentages.

For example, my All Seasons Portfolio is built as shown in the chart below. It is based on 5 core assets (equities, bonds, inflation-linked bonds, gold, and commodities), with the addition of VIX and cryptocurrencies.

The core concept of the risk parity portfolio is that you are prepared to face any economic environment that can develop at any time. If growth would stagnate, risk assets such as stocks and commodities would perform badly, but that would be offset by the positive performance of safe assets such as bonds and gold.

To some extent, this passive way of investing may feel limiting. While an All Seasons Portfolio is a safe foundation to stand on as an investor, there may come times when the balanced approach will be perceived as a constraint. This feeling of limitation could occur either when certain assets would be disadvantages in certain environments or when you want to take a bet on a trade to further improve your performance. You would then stand at a cross-roads with a choice of sticking with your balanced portfolio and your strategy on the one hand, and trying to take a bet and improve your return on the other hand.

This is were Dynamic Risk Allocation (DRA) comes to play. DRA is a temporary tactical shift in risk allocation where the investor can dynamically allocate more risk to certain assets at the expense of other assets. This is usually done in connection to expected shifts in environments. Therefore, when used right, DRA can improve the overall risk-adjusted return of the total portfolio.

For best use of DRA, it is best to beforehand have researched and implemented certain rules for what shifts to execute when. Otherwise, you are at risk at taking foolish bets, defeating the purpose of why you implemented a risk parity portfolio to begin with. To be clear, you do not need to set up all rules already before you begin investing, but identify them and implement them thoughtfully as you go along and as the situations emerge.

For even further reading, the book Risk Parity Fundamentals by Edward Qian elaborates more on dynamic risk allocation and other important aspects of risk parity investing, which you may feel useful.

In this book, the concept of dynamic risk allocation is described in great details, together with many other relevant topics to consider for the retail investor who looks for more balance in his or her portfolio, and for understanding how diversification between asset classes can further benefit risk-adjusted returns.

Or check out other great books on the topic on the Book recommendation page.

Check it out today on Amazon (affiliate link):