Burton Malkiel on risk parity in general, and Ray Dalio in particular

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Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by nisiprius »

Previous editions of A Random Walk Down Wall Street said nothing at all about risk parity. I was curious to see whether he would discuss it in the new, 2020 edition of the book. He does. (He discloses that he works for Wealthfront but otherwise says nothing about them or their risk parity mutual fund). Chapter 11 is entitled "New Methods of Portfolio Construction: Smart Beta and Risk Parity."

I was interested to see he supports risk parity mostly on the basis of superior risk-adjusted return from low-risk assets, such as bonds. Low correlation is not stressed.

We see this in (my own observation), the Sharpe ratios, (May 1992 - Oct 2020), for Total Stock and Total Bond having been 0.54 and 0.84, respectively. He mostly talks about this, rather than low correlation. Thus, for example, his illustration:

Image

This is coupled with fairly strong warnings on the risks of leverage, so that he suggests risk party "for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage."

In his own words, a part of his presentation is (my boldfacing):
There are two methods by which an investor can hope to increase the return and risk of a portfolio. One technique is to overweight the portfolio with higher risk assets such as common stock. A second plan is to invest in a broadly diversified portfolio with a substantial weighting of relatively safer assets promising modest returns and relatively low expected volatility. This relatively safe portfolio can then be leveraged up to increase both its risk and return. The essence of risk parity is that the second strategy can in some circumstances offer the investor a better expected return per unit of risk. To be sure, leveraging can create its own unique set of extra risks since a leveraged investor is less able to ride out a temporary storm that often engulfs financial markets. But for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage, the bargain offered by risk-parity portfolios may be sufficiently attractive to deserve a place in the overall portfolio. There is considerable evidence that individuals appear to overpay for wagers that offer a slim likelihood of winning but a large potential payoff if they are successful....

In the world of asset classes there are also favorites and long shots. And there also appears to be a tendency for investors to overpay for the long shots. A striking similarity between payoffs in the stock market and at the race track is that there is a tendency for people to overpay for investments with high risks but a possibility for unusually high returns. Very safe stocks (and other safe assets) appear to offer higher returns than their risk would warrant.
He also has some interesting observations on Ray Dalio:
Ray Dalio is a unique individual. He is at once a billionaire who is one of the richest people in the world and a number one best-selling author. He runs the largest hedge funds in the world at Bridgewater Associates, where he developed the enormously successful risk parity fund, called the All Weather Fund. In his book, entitled Principles, he describes the more than 200 principles that guided his firm.

Whether Principles is a template to show people how to succeed in the investment business is unclear. Certainly one can't argue with the idea that investment strategies must be "evidence based" and tested against vigorous debate and criticism of others. But the work environment that Dalio created at Bridgewater has been described as toxic.

Dalio insists that employees be constantly evaluated with "radical honesty" rather than with kindness in an attempt to bring their performance up to a higher level. Each day observations (so- called dots) are collected regarding the effectiveness of the organization and its individual people. All meetings are taped. Employees are subject to public criticism, and each one has a baseball card detailing his or her weaknesses that is available online for everyone in the organization to see. The public criticisms of employees who don't measure up are called "public hangings." Employees are told to look to the example of a pack of hyenas murdering a young wildebeest as a blueprint for how to deal with each other in the workplace. Small wonder that a third of Bridgewater employees leave the firm within a few years. One employee complained to the Connecticut Commission on Human Rights that Bridgewater was a "cauldron of fear and intimidation." But there is no denying that the organization has produced uncommon investment results. And some people have appreciated this hardline culture.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by chassis »

nisiprius wrote: Sat Nov 21, 2020 1:42 pm Previous editions of A Random Walk Down Wall Street said nothing at all about risk parity. I was curious to see whether he would discuss it in the new, 2020 edition of the book. He does. (He discloses that he works for Wealthfront but otherwise says nothing about them or their risk parity mutual fund). Chapter 11 is entitled "New Methods of Portfolio Construction: Smart Beta and Risk Parity."

I was interested to see he supports risk parity mostly on the basis of superior risk-adjusted return from low-risk assets, such as bonds. Low correlation is not stressed.

We see this in (my own observation), the Sharpe ratios, (May 1992 - Oct 2020), for Total Stock and Total Bond having been 0.54 and 0.84, respectively. He mostly talks about this, rather than low correlation. Thus, for example, his illustration:

Image

This is coupled with fairly strong warnings on the risks of leverage, so that he suggests risk party "for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage."

In his own words, a part of his presentation is (my boldfacing):
There are two methods by which an investor can hope to increase the return and risk of a portfolio. One technique is to overweight the portfolio with higher risk assets such as common stock. A second plan is to invest in a broadly diversified portfolio with a substantial weighting of relatively safer assets promising modest returns and relatively low expected volatility. This relatively safe portfolio can then be leveraged up to increase both its risk and return. The essence of risk parity is that the second strategy can in some circumstances offer the investor a better expected return per unit of risk. To be sure, leveraging can create its own unique set of extra risks since a leveraged investor is less able to ride out a temporary storm that often engulfs financial markets. But for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage, the bargain offered by risk-parity portfolios may be sufficiently attractive to deserve a place in the overall portfolio. There is considerable evidence that individuals appear to overpay for wagers that offer a slim likelihood of winning but a large potential payoff if they are successful....

In the world of asset classes there are also favorites and long shots. And there also appears to be a tendency for investors to overpay for the long shots. A striking similarity between payoffs in the stock market and at the race track is that there is a tendency for people to overpay for investments with high risks but a possibility for unusually high returns. Very safe stocks (and other safe assets) appear to offer higher returns than their risk would warrant.
He also has some interesting observations on Ray Dalio:
Ray Dalio is a unique individual. He is at once a billionaire who is one of the richest people in the world and a number one best-selling author. He runs the largest hedge funds in the world at Bridgewater Associates, where he developed the enormously successful risk parity fund, called the All Weather Fund. In his book, entitled Principles, he describes the more than 200 principles that guided his firm.

Whether Principles is a template to show people how to succeed in the investment business is unclear. Certainly one can't argue with the idea that investment strategies must be "evidence based" and tested against vigorous debate and criticism of others. But the work environment that Dalio created at Bridgewater has been described as toxic.

Dalio insists that employees be constantly evaluated with "radical honesty" rather than with kindness in an attempt to bring their performance up to a higher level. Each day observations (so- called dots) are collected regarding the effectiveness of the organization and its individual people. All meetings are taped. Employees are subject to public criticism, and each one has a baseball card detailing his or her weaknesses that is available online for everyone in the organization to see. The public criticisms of employees who don't measure up are called "public hangings." Employees are told to look to the example of a pack of hyenas murdering a young wildebeest as a blueprint for how to deal with each other in the workplace. Small wonder that a third of Bridgewater employees leave the firm within a few years. One employee complained to the Connecticut Commission on Human Rights that Bridgewater was a "cauldron of fear and intimidation." But there is no denying that the organization has produced uncommon investment results. And some people have appreciated this hardline culture.
@nisiprius Thanks, interesting. What is your view of this information? What are you doing, or not doing, with your investments as a result of this? What implications for investors do you see in this information?
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by 000 »

Thanks for sharing. I didn't know Dalio's fund was run that way.

I guess I'll share my thoughts on Risk Parity here, which are... we don't know all the future risks nor the probability distribution of the known future risks, so Risk Parity cannot actually be achieved. A more accurate term would be Past Volatility Parity, but given Dalio exiting fixed income it seems that Past Volatility Parity requires active management and market timing, which is probably not a good strategy for most individual investors.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by nisiprius »

chassis wrote: Sat Nov 21, 2020 4:49 pm...@nisiprius Thanks, interesting. What is your view of this information? What are you doing, or not doing, with your investments as a result of this? What implications for investors do you see in this information?...
He presents it more simply than others. He says 60/40 has been suboptimal. A lower stock allocation would have given a higher Sharpe ratio, mostly for the simple reason that bonds have had a higher Sharpe ratio than stocks. He suggests that for those investors who want more return, are willing to take more risk, and are willing to take on the additional risks of leverage, using a low stock allocation and increasing risk by using leverage may be preferable to increasing risk by increasing stock allocation.

Malkiel says "for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage, the bargain offered by risk-parity portfolios may be sufficiently attractive to deserve a place in the overall portfolio." Since I don't have high net worth and don't have the temperament to accept the additional risks of leverage, the implications are that risk parity isn't suitable for me.

I have long been puzzled by the prevalence of the 60/40 portfolio. For year I assumed it was an MPT optimum (tangent portfolio), but when I began to do my own exploring I realized that it wasn't. It's actually quite hard to find any time period over which it is even close to an optimum. For example, over the approximate time period in which I've been investing, 1980-present, it's been about 33/67. So Malkiel's comments are valuable to me as one more indication that I wasn't wrong about 60/40 having a suboptimally high stock allocation.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by Uncorrelated »

nisiprius wrote: Image
The way this image is drawn suggests that the risk parity portfolio is the tangency portfolio, but that is almost never the case. RP is not the tangency portfolio.

I'm starting to become repetitive, but my mean-variance optimizer is capable of finding a better solution than risk parity. With some assumptions (most notably, availability of free leverage and very specific return assumptions), the solution is identical to risk parity. I dismiss these assumptions on the grounds of plausibility.


Since most investors are leverage averse, there are strong theoretical reasons to suggest assets are priced as such that it's possible to increase risk-adjusted return by leveraging low-risk portfolio's. However, selecting the right portfolio is much more complicated and more sensitive to estimation errors than unleveraged portfolio's.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by JBTX »

nisiprius wrote: Sat Nov 21, 2020 10:26 pm
chassis wrote: Sat Nov 21, 2020 4:49 pm...@nisiprius Thanks, interesting. What is your view of this information? What are you doing, or not doing, with your investments as a result of this? What implications for investors do you see in this information?...
He presents it more simply than others. He says 60/40 has been suboptimal. A lower stock allocation would have given a higher Sharpe ratio, mostly for the simple reason that bonds have had a higher Sharpe ratio than stocks. He suggests that for those investors who want more return, are willing to take more risk, and are willing to take on the additional risks of leverage, using a low stock allocation and increasing risk by using leverage may be preferable to increasing risk by increasing stock allocation.

Malkiel says "for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage, the bargain offered by risk-parity portfolios may be sufficiently attractive to deserve a place in the overall portfolio." Since I don't have high net worth and don't have the temperament to accept the additional risks of leverage, the implications are that risk parity isn't suitable for me.

I have long been puzzled by the prevalence of the 60/40 portfolio. For year I assumed it was an MPT optimum (tangent portfolio), but when I began to do my own exploring I realized that it wasn't. It's actually quite hard to find any time period over which it is even close to an optimum. For example, over the approximate time period in which I've been investing, 1980-present, it's been about 33/67. So Malkiel's comments are valuable to me as one more indication that I wasn't wrong about 60/40 having a suboptimally high stock allocation.
If one had the foresight to know that from 1980 to 2020 interest rates would go from 20% to zero, of course an optimal portfolio would have overweighted long duration bonds. My perception is 60/40 is based on having no forward prediction ability.

I found the part about the work environment very interesting, and not at all a place I'd like to work. At the same time, I'm not sure how it is relevant to the topic at hand. I've heard similar anecdotes of extreme unpleasantness surrounding Elon Musk or Steve Jobs.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by BigMoneyNoWhammies »

nisiprius wrote: Sat Nov 21, 2020 1:42 pm Previous editions of A Random Walk Down Wall Street said nothing at all about risk parity. I was curious to see whether he would discuss it in the new, 2020 edition of the book. He does. (He discloses that he works for Wealthfront but otherwise says nothing about them or their risk parity mutual fund). Chapter 11 is entitled "New Methods of Portfolio Construction: Smart Beta and Risk Parity."

I was interested to see he supports risk parity mostly on the basis of superior risk-adjusted return from low-risk assets, such as bonds. Low correlation is not stressed.

We see this in (my own observation), the Sharpe ratios, (May 1992 - Oct 2020), for Total Stock and Total Bond having been 0.54 and 0.84, respectively. He mostly talks about this, rather than low correlation. Thus, for example, his illustration:

Image

This is coupled with fairly strong warnings on the risks of leverage, so that he suggests risk party "for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage."

In his own words, a part of his presentation is (my boldfacing):
There are two methods by which an investor can hope to increase the return and risk of a portfolio. One technique is to overweight the portfolio with higher risk assets such as common stock. A second plan is to invest in a broadly diversified portfolio with a substantial weighting of relatively safer assets promising modest returns and relatively low expected volatility. This relatively safe portfolio can then be leveraged up to increase both its risk and return. The essence of risk parity is that the second strategy can in some circumstances offer the investor a better expected return per unit of risk. To be sure, leveraging can create its own unique set of extra risks since a leveraged investor is less able to ride out a temporary storm that often engulfs financial markets. But for investors (especially those with high net worth) with the capacity and temperament to accept the additional risks of leverage, the bargain offered by risk-parity portfolios may be sufficiently attractive to deserve a place in the overall portfolio. There is considerable evidence that individuals appear to overpay for wagers that offer a slim likelihood of winning but a large potential payoff if they are successful....

In the world of asset classes there are also favorites and long shots. And there also appears to be a tendency for investors to overpay for the long shots. A striking similarity between payoffs in the stock market and at the race track is that there is a tendency for people to overpay for investments with high risks but a possibility for unusually high returns. Very safe stocks (and other safe assets) appear to offer higher returns than their risk would warrant.
He also has some interesting observations on Ray Dalio:
Ray Dalio is a unique individual. He is at once a billionaire who is one of the richest people in the world and a number one best-selling author. He runs the largest hedge funds in the world at Bridgewater Associates, where he developed the enormously successful risk parity fund, called the All Weather Fund. In his book, entitled Principles, he describes the more than 200 principles that guided his firm.

Whether Principles is a template to show people how to succeed in the investment business is unclear. Certainly one can't argue with the idea that investment strategies must be "evidence based" and tested against vigorous debate and criticism of others. But the work environment that Dalio created at Bridgewater has been described as toxic.

Dalio insists that employees be constantly evaluated with "radical honesty" rather than with kindness in an attempt to bring their performance up to a higher level. Each day observations (so- called dots) are collected regarding the effectiveness of the organization and its individual people. All meetings are taped. Employees are subject to public criticism, and each one has a baseball card detailing his or her weaknesses that is available online for everyone in the organization to see. The public criticisms of employees who don't measure up are called "public hangings." Employees are told to look to the example of a pack of hyenas murdering a young wildebeest as a blueprint for how to deal with each other in the workplace. Small wonder that a third of Bridgewater employees leave the firm within a few years. One employee complained to the Connecticut Commission on Human Rights that Bridgewater was a "cauldron of fear and intimidation." But there is no denying that the organization has produced uncommon investment results. And some people have appreciated this hardline culture.
nisiprius,

As someone who posted to and followed along on the Excellent Adventure thread, what were your takeaways from this as it pertains to the Hedgefundie portfolio? With the Hedgefundie portfolio he seemed fairly adamant that the strategy was heavily predicated on a negative correlation existing between equities and LTTs during a market crash and that the strategy would likely still work despite not being able to repeat the ample returns from fixed income caused by the steady decline in rates for the last 20+ years, which seems to not necessarily comport with what I'm reading above unless I'm missing something. Is the correlation between the broader US equities market that drastically different between something like say, BND and TMF?
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by xxd091 »

Nisiprius -Very interesting and well explained
Your remark about 33/67 having been the most successful combination over the last decade or two rings true with me
75 -retd 18 yrs-U.K. Boglehead
I was a little more conservative 30/65/5 -equities/bonds/cash
2 funds only
A Vanguard Global Equities Index Tracker and a Vanguard Global Bond Index Fund hedged to the Pound and that’s it
Did and is doing the job for me after resisting the siren song of more equities, alternatives etc
Ozark 42 and the Bogleheads seemed to realise this over the years
Lucky to have found this forum so long ago!
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by Blue456 »

There is always going to be a portfolio more optimal than yours during certain time period. I find it more valuable to see how a portfolio behaves during different economic periods such as inflation, recession and growth.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by dont_know_mind »

The main problem I have with RP is that it relies on levering an asset which is central bank controlled (long term government bonds).

With rates nearing the 1.5% on 30 years, being levered long bonds reminds me of people leveraging a pegged currency every time it deviated above the peg. This works until it doesn't. The most recent example of this that I can recall was when the SNB let the CHF/EUR peg break. People were levered 5:1 to 100:1 on CHF pairs thinking that the central bank would not let it fail. This thinking was based on years of volatility data since the peg indicated that it had low volatility. The dynamic was that the central bank could not indicate that it was thinking of letting the peg break because this would cause an avalange of selling (which it did) and a 20+ standard deviation move. I guess risk can happen fast. Hopefully not for the RP crowd.

With rate curve control in some countries, I wouldn't have the balls to lever bonds. It probably will work out fine, but I don't do anything where I could die.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by lyrictulip »

nisiprius wrote: Sun Nov 22, 2020 8:29 am
If you have a real source for "60/40," other than tradition and conventional wisdom, I'd like to see it. I've made a few feeble attempts to find out where 60/40 came from, and didn't succeed. Everyone has plausible stories of where they think it might have come from.
For what it’s worth (if anything), the “Sharpe Portfolio”, or the current global asset allocation of investment grade bonds and float/market weighted stocks, is presently 55/45, giving at least one highly arguable datapoint that the “optimal” portfolio, as determined by the market today, may roughly approximate 60/40.

So you can add that to the list of plausible stories of where I think it might be coming from.

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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by nisiprius »

BigMoneyNoWhammies wrote: Sun Nov 22, 2020 4:39 amnisiprius,

As someone who posted to and followed along on the Excellent Adventure thread, what were your takeaways from this as it pertains to the Hedgefundie portfolio? With the Hedgefundie portfolio he seemed fairly adamant that the strategy was heavily predicated on a negative correlation existing between equities and LTTs during a market crash and that the strategy would likely still work despite not being able to repeat the ample returns from fixed income caused by the steady decline in rates for the last 20+ years, which seems to not necessarily comport with what I'm reading above unless I'm missing something. Is the correlation between the broader US equities market that drastically different between something like say, BND and TMF?
I was specifically interested in what Burton Malkiel had to say, i.e. yes, I was looking at "a guru."

I don't know what to say about HEDGEFUNDIE (he styles his screen name in uppercase). I perceive him to be sophisticated and well informed on technical details regarding single-day-leveraged ETFs, and he has stated his positions carefully here. I will state my own ignorant opinions. I think negative correlations are perpetual motion. More carefully: a robust, persistent, negative correlation with stocks, combined with non-negative return, is perpetual motion, because it implies a way of erasing risk. If you have such an asset, you can get the risk premium of stocks without actually taking the risk. I think that is what he aims to do. My belief is that due to sampling variation and market vagaries, such conditions can occur, but I don't think they can persist. And in fact, correlations between stocks and bonds simply have not been negative over long periods of time.

Image

HEDGEFUNDIE has acknowledged this and said that there was a secular change in the fundamental nature of the bond market and that indeed the period of negative correlation only began in about the year 2000. I think he ascribes this to identifiable Fed policy actions, and expects it to persist.

So, as I noted, one of the things that struck me about Malkiel's discussion is that in his mind, the chief justification for risk parity is not persistent negative correlation, but higher risk-adjusted reward for less risky assets.

Malkiel says nothing about single-day-leveraged ETFs one way or the other.

The farthest I'll go personally is that I'm not interested in WisdomTree's NTSX "90/60" ETF, which seeks to provide the equivalent of 1.5X on a 60/40 allocation, but if someone were to offer a similar product with a "45/105" (1.5X leveraged 30/70)... with the LETF virtue of not being able to lose any more money than you put into it... I might be interested in looking at it.
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Re: Burton Malkiel on risk parity in general, and Ray Dalio in particular

Post by goodenyou »

Out of curiosity, what is the definition of "high net worth" in this discussion?
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