Fighting a bout of insomnia the other night, I happened to catch a show on the National Geographic Channel called Doomsday Preppers. The show presents the lives of so-called “preppers” or people who are taking steps now to prepare for what they perceive as an imminent apocalyptic event or societal collapse. In one of the profiles, a prepper was building a heavily-armed, underground bunker to protect his family against a future that he believed involved a worldwide economic collapse that would be followed by riots caused by food and energy shortages. Yet, despite taking some extreme steps to protect his family against this scenario, there he was a few scenes later testing out a homemade boat on a lake with his three young children, all of whom were without life jackets. And therein lies the problem with focusing solely on one particular risk: many other types of risk, which often represent a more clear and present danger, go unnoticed until it is too late.
Investor Tunnel Vision
Many investors suffer from the same tunnel vision when it comes to protecting their portfolios against risk. The first and foremost risk on most investors’ minds is market risk; they want to protect themselves against bear markets or significant declines in their stock investments. This is understandable and almost predictable as studies in behavioral finance clearly show that investors suffer from loss aversion in that they will typically do anything to avoid losses in their portfolio. Market risk is important, but it is not the only risk that investors face. Other risks of investing include inflation risk, interest-rate risk, credit risk, currency risk, and shortfall risk. These risks are certainly less noticeable, but that does not mean they are more benign.
As an illustration, take an investor who is worried about protecting his or her portfolio against what he/she views as an imminent bear market. To accomplish this, a typical reaction would be to exit stocks and move the proceeds to cash or bonds. Once that reallocation is complete, the investor no longer owns stock, so there is no longer any market risk in the portfolio. This much is true, but it would be incorrect to assume that there is no longer any risk in the portfolio. By owning more bonds, the investor has now increased the portfolio’s interest-rate risk, and by holding more cash in a no interest-rate environment, the investor has significantly increased the amount of inflation risk in the portfolio. If the investor requires an annual return of 8% to meet his/her retirement goal, then the longer the portfolio remains in cash/bonds the higher the amount of shortfall risk, or the risk that an investor will fall short of his or her financial goals due to insufficient funds—a result of insufficient returns in this example.
This is where the concept of “risk parity” comes in to play. The risk parity approach to investing seeks to balance the various sources of risk across a portfolio. The best way to conceptualize it is through a traditional asset allocation framework, but instead of simply diversifying your exposure to the various asset classes like stocks, bonds, real estate, and commodities, you are diversifying your exposure to the various risks of investing.
The pie charts below illustrate the difference between a portfolio that is balanced in terms of risk and one that is not. For the unbalanced portfolio, this would be a case similar to the one described above, in which an investor is overly concerned with cutting his or her exposure to stock market risk while ignoring that the subsequently higher cash and bond exposure leaves the portfolio overexposed to inflation risk, interest-rate risk, and shortfall risk—all of which can undo a financial plan just as easily.
Because most investors will naturally overemphasize market risk due to the behavioral tendency to avoid losses, the concept of risk parity is a helpful tool in focusing your attention on the full spectrum of risks that can potentially affect your portfolio and your financial goals. However, we will be the first to admit that it comes up a bit short in assessing the risk of widespread anarchy on your investments, but at least most of the risks will be covered.