The institutional investment sector is rapidly adopting more balanced asset allocation methods as investors realize that concentrated portfolios are risky and unnecessary for reaching their return expectations. To create a well-balanced portfolio, the investor must first comprehend how risky parity may be achieved. It could be accomplished by constructing a portfolio based on a fundamental understanding of the environmental sensitivity inherent in asset class pricing structures.
Risk parity refers to balancing a portfolio's risk exposures in order to achieve a higher possibility of financial success than traditional, equity-centric asset allocation methodologies.
To do this, a typical portfolio usually relies on correlation and volatility assumptions. Correlations, on the other hand, are unstable and unexpected, and they tend to alter in the most inconvenient ways at the most inconvenient times. Furthermore, volatility (asset risk) is difficult to forecast, and when things go wrong, risks tend to rise. Most risk metrics do not fully capture the possibility for long-term bad conditions that can result in low returns.
Typically, investors believe that equities and bonds are negatively correlated and that these asset classes are sensitive to growth surprises in different directions. They are, however, both sensitive to inflation surprises. So, how will we know what the future correlation of these asset classes will be? You can't truly know without knowing what the future economic environment will be like, which is an issue if you're attempting to put together a portfolio that will do well in any situation.
Only by balancing a portfolio based on the relationships between assets and their environmental factors, rather than on correlation assumptions, can you achieve dependable diversification. Although asset classes have a risk premium that is largely the same once risk is taken into account, their underlying sensitivity to changes in the economy is not. As a result, an investor should construct a risk-adjusted asset class portfolio in such a way that their environmental sensitivities consistently offset one another, leaving the risk premium as the primary driver of returns.
We all know that the most crucial factors are growth and inflation. This is because the volume of economic activity (growth) and the pricing of that activity define the aggregate cash flows of an asset class and the rate at which they are discounted (inflation). The major factors determining asset class returns are whether growth is more or lower than expected and whether inflation is higher or lower than expected, as well as how discounted growth and inflation fluctuate. The lengths and sources of variability of the assets' cash flows provide solid and knowable correlations between asset performance and growth and inflation.
Investors should take advantage of these consistent relationships by allocating similar risk exposure to assets that perform well when (1) growth rises, (2) growth falls, (3) inflation rises, and (4) inflation falls (all relative to expectations), through four sub-portfolios designed to capture these four risk exposures.
Rising growth/inflation assets reacted in the same magnitude as falling growth/inflation assets but in the opposite direction. By balancing rising assets against dropping assets, the impact of these environmental alterations would have been reliably reduced.
The outperformance of another asset class with an opposing sensitivity to that environment will automatically offset the underperformance of a given asset class relative to its risk premium in a given environment, leaving the risk premium as the dominant source of returns and producing a more stable overall portfolio return.
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