Portfolio Update – August 2021 – Retail Investors’ Irrational Expectations of Risk Parity
What I have observed from discussions with retail investors who are not yet aware of the benefits of risk parity, is that there is a great misunderstand of the goals of risk parity, and incorrect expectations of what such strategies should provide.
When explaining what risk parity is, being a strategy that pieces together risk premiums and returns from a wider array of asset classes, but where the timing of the earned positive returns from each asset are spread out in such a fashion that during all economic regimes, some of the assets will see negative returns, but the positive returns of other assets will offset losses and provide your portfolio with an overall profit.
This means that through proper diversification, on a portfolio level you cancel out much of the volatility inherit in each of the individual asset classes, so that you get a much smoother ride with lower portfolio volatility, but can still expect equity-like returns over time. You should expect rolling hills and valleys rather than mountains and canyons.
But as I have alluded to in recent posts, even though the All Seasons Portfolio strategy and other similar strategies (Golden Butterfly, etc. for example) are rationally the best fit for most investors, during times when the stock market outperforms, it becomes difficult to see your neighbor get richer on the stock market while your safe portfolio lags.
This kind of underperformance fatigue sets you up for a great risk if you abandon the safe strategy for a high-risk strategy when the market crash (the one that you were protected against) occurs.