Balancing asset classes according to their risk
Alternative or complementary strategies to the Modern Portfolio Theory have emerged in the last few years.
At certain moments (a good example is the last financial crisis in 2008-2009) diversification done with different asset classes is distorted. This means that all asset classes move in the same direction losing the fundamental concept of Modern Portfolio which is risk reduction. This happens because equity is responsible for 85% of the volatility and volatility is exacerbated during certain periods of time.
The Risk Parity concept emerged as an alternative to these situations. Risk Parity tries to solve the unbalanced risk searching for a more balanced contribution to risk for each type of asset. This is achieved by reducing our exposure to equity and increasing the weight of fixed income.
Purely speaking of RP, to avoid a reduction in the expected returns, the reduction is offset by leveraging the portfolio, partially reducing equity’s weight while fixed income positions are significantly leveraged, obtaining a much better diversified portfolio in terms of risk.
We can see this by comparing the two illustrative charts.
Some studies published by those who advocate RP show how in the last two decades this strategy would have increased the annual return by a 2%. However, the most interesting fact is that it reduces volatility by a 2.5% doubling the Sharpe ratio (from 0.4 to 0.8).
Inbestme applies to diversified portfolios some of these alternative and complementary concepts.
When certain circumstances make it advisable to leave assets that are in a correction phase, some systems already exist in order to reduce risk.
We actively manage of our portfolios and this allows us to incorporate opportunistic assets according to the market situation or dynamic changes in the asset classes especially in times of high volatility. We do this in such a way that we reduce the chances of loses and that in the long-term ends up generating additional returns thus bringing the odds for success to our side.