Risk Parity and How It Achieves Better Diversification than the 60/40 Portfolio

Reconsidering 60/40

2022 started with a sharp decline in the traditional 60/40 portfolio. The 18% fall in the portfolio is the worst since 1976, even considering the 2001-2002 dot-com bubble burst and 2008 financial crisis. 

However, the stock-bond diversification of 60/40 protects investors to some extent, and these 60/40 portfolios do eventually recover. For retail investors who want simple, easy, and effective diversification, 60/40 has been the method of choice for a long time and can still work. But here are some points that no investor can deny:

1. 60/40 provides less-than-impressive returns over the long term when compared to a portfolio with a larger equity allocation.
2. 60/40 does not prepare you for situations when inflation comes in above expectations.
3. 60/40 is not geographically diversified.
4. 60/40 does not invest in new alternative asset classes that have high return potential over the long term (crypto, for example).
5. 60/40 does not allocate to asset classes that provide valuable diversification and are popular among professional investors such as commodities, gold, and inflation-linked bonds.
   

Before we move on to the other issues listed here, let’s make one thing clear: it is possible to enhance the returns of a traditional 60/40 portfolio using financial engineering or leverage. But what is leverage? How does it work? Can you try it out as a retail investor? Let’s explore these questions and also discuss a more optimal alternative to 60/40 that protects an investor in all market environments.

What is Leverage?

Leverage means borrowing capital and using it to invest in assets instead of putting up more of your own cash. It also refers to the debt businesses and individuals take on for expanding or investing.

Using leverage can amplify both your risks and returns. 

Here’s an example.‍

Your friend just offered you a chance to invest in a company he’s building. For now, he promises that if the company signs up 1000 customers in a month, you’ll get double of what you invested every following month. But if it fails to do so, you’ll lose your principal investment. The plan sounds excellent to you, and you’re pretty confident he’ll succeed. But you only have a $100 to invest for now.

Since you’re so confident, you decide to take a loan of $5,000 and put it all in your friend’s company along with your $100. If the plan fails, you’ll lose your own money plus the loan you took. And to repay that loan, you’ll have to again fork out your own money. Naturally, because you took the loan, your risk increased and you lost so much more. 

But what if the plan works? You’ll have $10,000 in two months. While you will have to return the principal borrowed ($5,000) plus interest, you’ll still be left with an amount close to $5,000. If you hadn’t taken that loan, it would have taken you a lot longer to make $5,000 with just a $100 investment. So in this case, leverage increased your potential for returns.

Leverage can come in different forms:

Futures: contracts that let you fix a future date to buy/sell a commodity or security at a fixed price

‍Margin Loans: Loans taken by investors to purchase securities. They are most commonly used in equity markets and involve high interest rates. That is why they are not great for leveraging alternative investments. 

‍Call Options on Equities and ETFs: A complex form of leverage that depends highly on predicting future market scenarios.

How Does Leverage Work for Investors?

The principle behind using leverage is pretty straightforward. Generally speaking, the riskier an asset, the greater its return potential. In other words, the amount of return you get from an asset in your portfolio can be modified by changing the amount of risk you take on for that particular asset (by investing more/less capital in it).

Think of it this way: stocks are inherently more volatile. In a 60/40 portfolio, since you invest 60% of the capital in stocks, you put most of your portfolio’s risk in equities. If you were to lower the percentage of capital invested in stocks, you would lower the risk they contribute to your portfolio as well.

Going by this principle, investing in bonds after levering their risk up to match stock-risk, investors can achieve better returns even with bonds. By modifying an investment strategy using leverage, low-risk, low-return assets can be converted to high-risk, high-return assets.

For most investors, leverage is a way to increase cash flow. Using debt, an investor can put up borrowed money to invest in an asset. They can use their own money to either invest more in a low-risk asset class or to diversify beyond one or two asset classes. 

But debt is not the only way to utilize leverage in a portfolio. An interesting and more complex tool is a futures contract. 

What are Futures?

Futures, as mentioned earlier, are derivative financial contracts between two parties that fix a future date for buying/selling a commodity/security.

Futures are intricate and contain clear contract specifications based on a centralized exchange such as the CME Group. These centralized exchanges remove the need for investors to negotiate custom futures contracts with financial institutions such as banks and make leverage quicker and more accessible.

Futures usually deal in underlying assets within an asset class. For example, a commodities future would deal in crude oil, grains, etc. Similarly, stock futures would deal in the S&P 500 Index and U.S. Treasury futures would deal in financial securities like bonds.

Back to Leverage and 60/40

Using futures on long-duration bonds, the 60/40 portfolio’s returns can be adjusted to those of an equity-concentrated portfolio without increasing the risk.

Whether it is via futures or borrowed money, leverage is an age-old way of enhancing returns and hedging against market downturns. However, because of the complexity and high level of risk involved in leverage, it’s used mostly by professional or institutional investors.

Warren Buffet is an excellent example of such an investor. Over the years, he has relied heavily on leverage to enhance his returns. Researchers at New York University and AQR Capital Management pointed out in 2012 how the efficient use of 1.6x leverage has made Berkshire’s returns especially impressive over the years:

“Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return…” (Source)

Buffet is seen as a stock-picking god today. But part of his success comes from using Berkshire’s investment premiums paid upfront by policyholders. Unless Berkshire has to pay up claims, this money is essentially an interest-free loan. Using this borrowed money, Buffet invests in low-volatility, low risk stocks (also called low-beta stocks). 

The strategy is risky of course, because if Berkshire undercharged policy holders or if the policies were short-term, it would end up losing money. But because insurance is long-term stable money, Berkshire has profited from it even when its own shares have underperformed. The researchers further highlight that most of Buffet’s stock market performance can be attributed to leveraged low-beta stocks.

Similarly, if leverage is applied to short-term, low risk bonds, it can be used to enhance the traditional 60/40 portfolio. Using leverage to invest in assets that have lower risk or volatility, a short maturity period, and greater liquidity can be an excellent way to hedge your portfolio against risk while still obtaining equity-level returns.

As an investor, if you use leverage to strategically diversify your portfolio, it can improve returns without increasing risk.

How? Because leverage can make the overall impact of different types of assets similar.

Equities provide more returns but also have more risk. Bonds don’t have as much risk but also don’t provide high returns. Investing 25% in equities and 75% in bonds gives you lower returns. But if you invest more money in bonds while keeping the amount invested in equities constant (25%), you’ll have more returns from bonds as well. In a 25-75 setup, you’ve already utilized 100% of your capital. So how do you find more capital to invest more in bonds? By using leverage, that’s how. 

A levered 60/40 portfolio is more capital efficient, too. For each dollar of capital you invest in such a portfolio, you would get more than a dollar’s worth of risk-exposure and consequently better returns. For example, a 60/40 with 1.6x leverage would give you $1.6 worth of exposure for every $1 invested.

Essentially, a diversified and leveraged investment portfolio is less risky and provides better returns than a non-diversified, unleveraged one. 

Is a Leveraged 60/40 Portfolio the Best?

Leverage does improve the returns of a traditional 60/40 portfolio. But the other issues with 60/40 still remain. The portfolio doesn’t protect investors in inflation-driven market environments or against geographical market shifts. 

Moreover, it’s generally not diversified enough, and drawing on lessons from the last article, diversification is essential for better returns, protection against risk, and general long-term wealth management.

Due to these reasons, retail investors who maintain a typical 60/40 portfolio with little to no concentration in other asset classes get burned when market environments suddenly change. Currently, for example, with inflation running high, both equities and bonds are doing poorly. Even with leverage, these two asset classes can’t protect you from low returns.

An ideal investment portfolio consists of negatively correlated assets that do well in different market environments. But how do you know which is the right asset class and how much risk it contains? Using a formula known as the Sharpe ratio, you can measure the risk per unit of return for an asset class and decide how much capital to allocate to it. 

What is Sharpe Ratio?

Sharpe ratio is a way to measure the risk-adjusted returns of an asset or investment. While investing in any asset class, your goal should be to maximize returns while keeping risks low. Using Sharpe ratio can help you evaluate which asset classes can improve your portfolio while balancing its risk and enhancing returns. 

Sharpe ratio can be used to evaluate a particular investment or your entire portfolio. Either way, it compares the rate of return on the asset/portfolio against the risk-free rate of return (usually, the rate of return on a short-term U.S. Treasury Security). 

Here’s an example to help you understand how Sharpe ratio works to give you a better, risk-adjusted picture of a portfolio or asset. 

Let’s consider two portfolios: portfolio A and portfolio B. 

Portfolio A has annualized returns of 15% while Portfolio B has annualized returns of 10%. Naturally, portfolio A seems to be the better choice if you look at only the rate of returns. But evaluating the two portfolios in light of their risk-adjusted returns is super important to make the right choice. 

Let’s take the risk-free rate of return to be 3%. If Portfolio A has a standard deviation of 8% but portfolio B has a standard deviation of 3%, their Sharpe ratios would be:

Portfolio A = 1.5

Portfolio B = 2.33

Since portfolio B has a better Sharpe ratio, it has better risk-adjusted returns and may be the superior choice over portfolio A. 

In a similar way, using Sharpe ratio, you can determine which assets are a good fit for your investment portfolio based on how much risk you have to take on while investing in them and whether or not they provide comparatively better returns. As a retail investor, even if you can’t calculate the Sharpe ratio of an investment yourself, just looking at the ratios of different investments can easily help you understand which might be the better choice.

Evaluating the risk-adjusted returns of assets and allocating capital to each of them accordingly is the key to building a great long-term investment portfolio.

Risk Parity: The All-Weather Portfolio

Calculating the risk-adjusted returns of assets and building a portfolio based on that can be an excellent way to diversify. This strategy, often called risk-parity or the all-weather strategy, has been pioneered by hedge funds and institutional investors for decades now. 

What is Risk Parity?

Risk parity is an investment strategy that focuses on designing a stable investment portfolio that should perform well across all types of market environments. Using risk parity, investors can combine a variety of asset classes that balance each other out in terms of risk such that when market environments change, some assets perform well while others take a hit, but the portfolio returns remain relatively stable.

Generally, this means determining the risks different types of investment options have for all possible market conditions and investing in them such that each contributes equal risk to the overall investment portfolio. At the same time, it also means holding a diverse group of assets and adding some leverage to adjust returns to desired target levels.

How Risk Parity Works

‍Growth and inflation are the primary macro drivers in most financial markets. Both growth and inflation can come in above or below expectations suddenly, and such changes end up affecting your portfolio’s returns. This is because all asset classes have environmental biases; they do well in certain market environments and poorly in others.

As a general rule, equities perform well in periods of rising economic growth, whereas nominal bonds do well when economic growth falls. Naturally these two can balance each other out to provide you a portfolio that has stable returns and minimal risk, be it rising or falling growth conditions. 

But what happens when inflation rises? Again, following the risk parity strategy, your portfolio should have similar returns as any other market condition. Both stocks and nominal bonds will fail to achieve such a return. But inflation-linked bonds and some types of commodities do well in such a scenario. 

Considering these factors, a risk-parity influenced investment portfolio will roughly look like this: 

In such a portfolio, you allocate your capital such that the risk contributions by all types of assets remains the same (25% in this case). Some assets perform well in rising market conditions, while others perform equally well in falling ones. Either way, your portfolio’s overall returns remain balanced and stable.

Risk parity approach attempts to not put the fate of your entire portfolio in the hands of one type of asset. Instead, it asks you to distribute the percentage of risk equally among four different market environments. If you can’t predict how economic conditions will unfold, you should hold a mix of assets that can perform well across all different types of market environments. Doing so keeps you protected and your returns stable.

Risk parity is like being prepared for every situation without compromising on the end goal. Imagine if you were living in London - a place infamous for its unpredictable weather. You have to go to a friend’s birthday party, and it’s sunny outside so you wear shorts. But you also carry an umbrella and wear comfortable sneakers just to be prepared. Even if it rains, you’ll get to the party without messing up your outfit. 

Similarly, risk parity keeps you prepared for all sorts of “market weathers” without compromising your returns. Because of that, it is also called the “All-Weather Strategy.” 

How is It Different From Traditional Investing?

Usually, investors decide how much to put in an asset based on how well it’s performing currently or how it may perform in the future depending on market forecasts. For example, if you have $100 and you see that equities are performing excellently as compared to bonds, you might decide to put $70 in equities and $30 in bonds. 

Such diversification puts the maximum portion of your portfolio’s return in the hands of equities. If they fail to deliver because of a surprising market shift, your overall returns go down. 

In the case of risk parity, however, you base your investing decisions on just two things: 

1. Investments should provide good returns over the long term.
2. The market can shift suddenly in any direction, and different assets will react to the shift differently.‍
   

That’s it. You don’t predict what the market will look like a month from today. You don’t suddenly start shifting capital to bonds when you see a risky event occur. Instead, you just prepare for the best and worst possible situations and invest in a variety of assets, each of which do well in some situations. 

With risk parity, you invest in finding a balance of risks in the long-run, not returns. And if done right, returns follow.  

Another key difference between a typical retail portfolio and a risk parity portfolio is the use of leverage. Most retail investors diversify, but if the returns of a diversified portfolio are too low, they start concentrating more capital in high-risk, high-return assets. In risk parity, however, after balancing the portfolio for risk, if the returns are low, leverage is applied to increase them instead of modifying capital allocation. 

Pros of Risk Parity Portfolios

1. It Takes the Guesswork Out of Investments

People often base their investing decisions on the present and possible future market conditions. Markets react surprisingly to different scenarios. You can never expect to be 100% right when guessing how a particular situation will affect tomorrow’s markets. 

Risk parity takes the guesswork out of investments. It positions equally for all possible market outcomes. You are more likely to realize stable returns regardless of the market environment that unfolds. In other words, the portfolio volatility of a risk parity portfolio is much lower than a less diversified one.

2. It Can Perform Better Than a Conventional Portfolio

You can rebalance the 60/40 portfolio to reduce risk when markets suddenly change. But even doing so does not optimize returns the way risk parity does because you are only dependent on stocks and bonds for every situation. 

Because risk parity allows investing in more assets (stocks, bonds, commodities, inflation linked bonds, emerging market bonds, corporate bonds, crypto, gold, etc.) than just stocks and bonds, it allows investors to rebalance their portfolio better. In other words, the asset allocation in a risk parity portfolio is such that all assets have equal risk contribution. This, in turn, can lead to better returns in different market scenarios. 

3. Risk Parity Portfolios Require Less Management Than Active Investment Portfolios

If you’re not an active investor, you probably do not want the hassle of having to predict markets and shift capital from one type of asset to another. 

Risk parity portfolios don’t need frequent adjustments and predictions, which is why they’re less costly, easier to manage, and safer. 

Cons of Risk Parity Portfolios

1. You Need More Cash

Risk parity portfolios need leverage, and for leverage, you need more cash. Cash isn't always easily available, especially to retail investors.

2. It Often Relies Heavily on Low-Risk Bonds

To balance the risk posed by other assets, risk parity strategies often uses low-risk bonds. However, these bonds don’t perform well in certain market environments, which may cause an unwanted imbalance in the portfolio. 

3. It Still Needs More Management Than Fully-Passive Investment Portfolios

For someone who is not too keen on any active management of their portfolio at all, risk parity is not the right choice. While it does require less management than active portfolios, it’s still a strategy that requires financial engineering and regular rebalancing.

Despite its cons, Risk Parity is a more mature way of building an investment portfolio for long-term wealth. However, the active management and the initial financial engineering required to build an optimal risk-parity portfolio is difficult for retail investors due to (a) lack of knowledge, and (b) poor access to resources needed for such investments.

With apps like Hedgeful, retail investors get to build their long-term wealth just like institutional investors by investing in a risk-balanced, leveraged portfolio. Hedgeful also gives users exclusive access to eight major asset classes plus the tools and resources that are often only available to hedge funds and professional investors. With it, retail investors also don’t have to worry about actively managing their portfolio or understanding the intricacies of leverage.

Wrapping Up

Diversification is essential for any investor – retail or professional. Pros, however, tend to diversify cleverly by balancing risk rather than capital.

Professional investors also make use of financial engineering in the form of leverage (futures, swaps, margin loans, etc.) to enhance their returns and end up with better long-term returns compared to retail investors. 

With a risk parity strategy, retail investors, too, can get similar returns and remain protected from market shocks. This mature, all-weather strategy is often significantly better than a typical 60/40, both in terms of risk and returns.