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When investors populate their portfolios with stocks or equity ETFs, it is easy to forget just how exposed the portfolio is to risk. The following analysis is a reminder of the high risks we take when constructing portfolios. To know a little more about Risk Parity, check out this link.

Ivy-10 Analysis: The following portfolio is a modification of the Ivy-10 Portfolio. I substituted IWN for VB and GTU for GSG. Otherwise it is the Ivy-10. Without Risk Parity adjustments, this portfolio is projected to return 8.6% with a volatility of 9.5%. That projected return is likely high as the market return is set to 10.0%, an unrealistic figure. I will lower that rate in future analysis.

At the bottom of this screen show is the correlation matrix, pointing out why one includes bonds, treasuries, and commodities to build diversity.

(click to enlarge)

Risk Parity: The following screenshot is the key to this blog entry. Compare the Optimal row and percentage allocated to each ETF and then move down to the Risk Parity row and check out the allocation based on risk. Risk Parity is where the percentages are established based on risk rather than assigning a specific percentage to that asset class. BND and TIP carry the lowest volatility and that is why they receive the bulk of the allocation when using the Risk Parity (RP) approach. VTI has a much higher volatility and that is why only 3.3% of the total portfolio is allocated to that equity ETF.

Using a RP approach reduces the projected return to 4.7%, but it also lowers the projected volatility to a mere 2.5%. When using a lower projected market return, that 4.7% also declines in value.

I am new to this software so I am not completely familiar with the outputs and how to interpret them. For example, the Optimal percentages vary between the first and second screen shots. I think the difference is that in the first slide the optimization is based on asset classes, whereas in the second it is based on the individual ETFs. However, I am not positive of that interpretation.

If one is sensitive to risk, pay attention to the teachings of Risk Parity.

(click to enlarge)

Source: Risk Parity Analysis Of Modified 'Ivy-10' Portfolio