The So-Called "All-Weather" Portfolio

The So-Called "All-Weather" Portfolio

by Zach Marsh on Nov 1, 2019

Ray Dalio, considered one of the all-time greatest hedge fund managers, years back set out to build a portfolio allocation designed to withstand all of the four major economic environments.  The environments as defined by him were as such:  Low Growth/Low Inflation, High Growth/Low Inflation, High Growth/High Inflation, and Low Growth/High Inflation.  He didn’t focus on determining which environment the economy was headed toward, but rather what combination of assets would best holdup under the various potential outcomes.  He called it the “All-Weather Portfolio,” and it was designed as a portfolio to manage the money he planned to leave to his family. 

Now without spending too much time getting deep into the weeds, essentially what Dalio did was assess the various asset classes according to the volatility, or risk, of each asset.  The assumption is that if you wanted to effectively balance a portfolio you need to go beyond a simple, flat percentage allocation to stocks and bonds.  Stocks and high credit weighted bonds, like US Treasury bonds, are typically uncorrelated, and during times of market stress, frequently move in opposite directions.  For example, when stocks are falling, like the did in the fall of 2008, Treasury bond prices were going up because interest rates were collapsing.  But, the problem with this simple allocation strategy is that it failed to account for the projected move of each asset class.

Over the past 90 years or so stocks have typically had a volatility that is roughly 3 times greater than bonds.  So, for example, in 2008 when the S&P 500 stock index declined by roughly 40%, the return on the US 10 year bond was 20%, impressive, but not enough to offset the magnitude of the move in stocks with a simple 60/40 stock bond allocation.  However, if one had balanced the two according to each asset’s contribution to the overall risk, the allocation would’ve been closer to 35% stock and 65% bonds (essentially the inverse of traditional portfolio management).  Had you been in a portfolio with that weighting in 2008, you would’ve essentially not lost any money. 

In fact, looking back over the last 90 years of stock and bond returns, and breaking markets into cycles of growth and retraction, inflation and deflation, the returns of a risk balanced portfolio would’ve held up well under all climates.  Below are three tables of various economic cycles.  I’ve compared the average annual returns and the corresponding volatility of three portfolios:  100% stock, 60% stock 40% bonds, and Risk Balanced 35% stock 65% bonds.

 

Bear Cycle Returns

Bear Cycle Volatility

Years

Risk Parity

100% Stock

Traditional 60/40

Risk Parity

100% Stock

Traditional 60/40

1929-1937

2.10%

-3.20%

0.40%

10.80%

28.80%

17.70%

1969-1977

4.89%

2.88%

4.27%

9.34%

18.43%

12.79%

2000-2008

5.00%

-3.60%

2.10%

3.60%

19.00%

9.10%

 

 

Bull Cycle Returns

Bull Cycle Volatility

Years

Risk Parity

100% Stock

Traditional 60/40

Risk Parity

100% Stock

Traditional 60/40

1942-1965

7.20%

15.50%

10.50%

5.10%

15.90%

9.10%

1982-1999

13.40%

18.30%

15.30%

9.90%

11.60%

9.90%

2009-2018

6.10%

13.00%

8.90%

4.40%

10.80%

5.40%

 

 

Inflation Period Returns

Inflation Period Volatility

Years

Risk Parity

100% Stock

Traditional 60/40

Risk Parity

100% Stock

Traditional 60/40

1942-1948

6.55%

13.68%

9.37%

5.01%

13.68%

8.31%

1965-1980

4.90%

7.10%

5.90%

7.40%

17.10%

10.70%

 

 

 

 

 

 

 

Looking over these tables two things should stand out:  first returns of the Risk Parity portfolio are more consistent across all three economic environments; and second, the volatility of returns of the Risk Parity portfolio are significantly lower than the volatility of the all stock and the traditional 60/40 portfolio.  In fact, when analyzed over the entire 90 year history, the volatility of the Risk Parity portfolio is 8.35% compared to 19.47% of the all stock and 12.02% of the 60/40.  While the cost of assuming a lower volatility portfolio is reduced overall returns, but on a risk adjusted basis you are more adequately being compensated for the risk assumed by taking the Risk Parity approach. 

This was meant to be an illustrative examination of the Risk Parity concept.  The portfolio described is extremely rudimentary and does not encapsulate the total allocation or methodology of Ray Dalio’s fund or of the approach we take at Calibrate Wealth.  If you would like more information, please contact us and we can go over how this solution may be appropriate for you.

Thank you.   

 

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