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Building A Risk-Parity Portfolio: An Example

Stephen Nemo profile picture
Stephen Nemo


  • Risk-parity portfolios weight asset classes by volatility, and use modest leverage to boost returns while keeping volatility manageable.
  • This article will walk you through a simplified example of how to construct a risk-parity portfolio with 4 assets.
  • We will use the S&P 500, long-term treasuries, gold miners, and high-yield bonds in our example.
  • I will end with a prediction of how risk-parity portfolios will likely perform for the next decade: 5% CAGR, and 10% standard deviation of volatility.

The idea behind risk parity is simple: build a portfolio of uncorrelated assets, weighted according to their volatilities, and use modest leverage to boost returns while keeping volatility tolerable. Let’s try our hand at building such a construction.

We’ll use four asset classes, and for the purposes of being able to simulate the past 29 years of financial market history using portfoliovisualizer.com, we’ll only use mutual funds available since 1991.

  • US Stocks – S&P 500 (VFINX)
  • Long-Term Treasuries (VUSTX)
  • Gold Miners (INIVX)
  • High Yield Bonds (FHAIX)

Important note: I will use a lot of charts to illustrate portfolio performance in this article. In all of these simulations, all dividends were reinvested. Additionally, all portfolios were rebalanced annually.

A First Foray

If we knew absolutely nothing about these asset classes but had to assign each of them a portfolio weighting, we would probably resort to an equal weighting of 25% each. This is called the 1/N portfolio. Let’s simulate how this portfolio did (assume annual rebalancing):

Source: portfoliovisualizer.com

It looks very respectable – 8.9% annual returns with an 11.9% standard deviation for volatility. Assuming a bell-curved distribution of annual returns, this portfolio was and will likely be profitable in 77% of all 1-year periods. The maximum drawdown of 29.66% was caused by the 2008 financial crisis.

An Improved Allocation

You might be happy with this sort of portfolio already. But let’s ask for more: let’s try to improve it! Let’s dig into the mechanics of the portfolio and its statistical properties.

Source: portfoliovisualizer.com

These tables might look intimidating, but we’ll only focus on the parts that are boxed in green.

Firstly, notice that the S&P 500 (VFINX) had the highest CAGR, or annual return rate of all the assets. We are greedy, so we are tempted to increase the allocation. Let’s leave that for until later.

This article was written by

Stephen Nemo profile picture
I am a student studying mathematics, statistics, and economics. I write about whatever strikes my fancy.

Analyst’s Disclosure: I am/we are long HTGC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (46)



It uses a weekly rebalance in combination with a short look-back period to manage risk so it's highly unlikely you'll be caught with your pants down. You could combine the strategy with a huge permanent percentage of cash and still come out way ahead if you wanted to.

Original idea courtesy of @varan.

Suggestions are welcome.

Anson J. Glacy Jr., CFA profile picture
@drftr So every week you rebalance using risk-parity weights computed over the previous 21 trading days, right? How does the 63-day "performance window" enter into it? Many thanks.
Stephen Nemo profile picture
Try simulating a TQQQ-based portfolio starting from 1999 and you'll get a very different result.
There's no role for the 3 months period you're saying. But since it's not my software I can't take it out in any way. But whatever you enter there has no influence on the results as it's simply ignored. Like 1 month produces exactly the same. Good question.

Anson J. Glacy Jr., CFA profile picture
I think you're on the right track. PortVis back-testing is meaningless now that we have administered markets.

I also think that putting the lion's share of your assets into long-dated Treasuries returning 1.6% is folly. I understand the ballast they provide but perhaps a put contract might be a better idea.

I've been toying with this allocation: 60% SSO and 40% VFSTX (floating rate debt). The money supply is through the friggin' roof. Look at the Fred MZM chart. Yikes!
Stephen Nemo profile picture
I've recently toyed with the more extreme idea of going 25% TQQQ and 75% VCIT. You get 75% of exposure to QQQ while getting 3/4 the dividend yield of VCIT. The only problem with 2x and more so with 3x levered funds is that they go to zero quite often.

It takes a 50% decline in an underlying to cause the 2x levered fund to go to zero, and a 33% decline in an underlying to cause the levered fun to go to zero. So you have to either be really good at market timing and just let the 25% allocation go to zero, and rebalance back in when you think the market's bottomed, or you just constantly rebalance all the time, and eat the losses.

But that is just backtesting again - the past performance of the likes of Google, Microsoft, Facebook, and Apple are not guaranteed to happen in the future. My new pet endeavor is to screen small & micro cap stocks and look for ones with high revenue/cash flow growth and high returns on assets. You have to catch them when they're small!

As I said before about EDV/ZROZ - there's still a puff or two left in those proverbial cigar butts before their yield reaches zero. But if yield curve control becomes a thing, then I would agree with you that including them in risk parity is dead.
Anson J. Glacy Jr., CFA profile picture
Interesting story on yield caps on page B11 of today's WSJ. I guess free markets are dead in this country.
you basically don't understand math if you are saying, 33% drop in QQQ will cause TQQQ down to ZERO, lmao...look what happened in the past three months, did TQQQ went to 0? the largest it hit was 37 dollar. that's horrible with 75 percent down. well, TQQQ just made all time high:) what can you say?
Own Bonds of ARCC & MAIN.
Own Baby Bonds of HTGC.
Own Common of MAIN.
Just spreading my momey & risk around. Looking at the common of ARCC once the price comes down.
Angelo_A profile picture
Good article! Want to spice that a little? Try on portfolio visualizer 40% on cash, 25% on a proxy of virtus small cap core or on a Wilshire 5000 or other (just pick the best small cap risk return you find with least correlation to us market) 15% on a 3x bull tech, 5% on 3x bull long treasury, and 15% on a 2x bull intermediate treasury? Not set and forget, rebalance at least every quarter.
Should give a long term (20 year) Sharpe north of 1.1, sorting north of 1.7 and a calmar north of 2.
Stephen Nemo profile picture
Haha, you've been playing around with it too. 3x leverage makes anything looks like genius. The main problem with these schemes is the ability to sit through a fund going to zero if the unlevered fund goes down 33%, and the willingness to rebalance back into a fund that went to zero.
Angelo_A profile picture
That is true but backtesting it, it seems it never goes to zero. Still, I might be wrong :-)
Stay safe! And once more, it's a very well written article!
You seem to be equating volatility to risk. Risk to me is the risk of losing principal.
ty. excellent education.
Curious why BDCs will suddenly start outperforming SPY? I realize you pick two that look good in the rear view mirror but I postulate that IF SPY is overvalued as you say they leveraged businesses are probably overvalued, too.

Good thought piece but like all risk parity models is backward looking and for me not too helpful.
Stephen Nemo profile picture
Their dividend yield is on average about 8%. If SPY flat-lines for a year without any big credit events in the meantime, a solid BDC like ARCC or MAIN will outperform SPY.
bil1026 profile picture
"...since current 30-year bond yields are just ~1.6%, close to zero, there is essentially no room left for bond yields to fall."

That is a bold statement. Similar statements at 2%, 3%, and 4% were all proven wrong, and also uncovered the "bond guru" predictors as has-been, charlatan know-nothings.

There are future economic and central bank conditions that could rapidly drop the 1.6% yield to lower than .5% or less -- and those conditions may well be on the way as of right now.
Stephen Nemo profile picture
I would welcome being wrong on that statement.
It is an interesting thought experiment. Since so much of the investment flows are passive, say Vanguard target date funds, and the only decision is buy when they have money added, sell when they have redemption I think there is a chance that bond prices go absolutely crazy if issuance slows down and passive flows go up.
Levering up fixed income at multi generational low in yields and vol. What could go wrong?
Great article intelligent, well thought out. Thank you
FYI, a recent Morgan Stanley report [discussed in a Heisenberg Report article] noted that "low yields, higher volatility and less negative correlation are reducing the diversification benefit of bonds".
Stephen Nemo profile picture
Yes... while 30 year yields are still above 0%, there are still a few puffs left in this proverbial cigar butt. Just another 1% drop in the yield of EDV or ZROZ would produce another ~25% price bump.

If a price bump happens, you'd reallocate your portfolio away from these zero coupon bonds back into stocks. And when stocks recover, and zero coupon bonds drop again, you reallocate back into zero coupon bonds.

I do agree with Morgan Stanley's view that since long bonds are so close to the zero lower bound on interest rates, there's less room for them to jump up during a stock market rout.
BeaBaggage profile picture
I did not know EDV had zero coupon treasuries in it?

Not sure I'd want to start w a full allocation into any category now except miners as all seem extended historically. $ASA is a good discounted no levered way to play miners imo. Bea
TriniIndi profile picture
The Z in ZROZ stands for Zero coupon.
good read.
What's the difference between risk parity vs. Black Litterman scheme? I read risk parity does not depend on expected return. Is that a shortcoming?
For example if you expect bond return 1.6% going forward, why would you allocate anything? For me, investing long term bond going forward needs good timing since risk reward is not that better than cash.
HarborPark profile picture
Great article. But,

"It turns out EDV and ZROZ are quite good substitutes for EDV!"
Stephen Nemo profile picture
Thanks for the catch.
Great article. Is this a portfolio allocation, you would recommend for young savers in their 30s for long term capital appreciation?
Stephen Nemo profile picture
If I were to implement this right now, I would put a 40% allocation into VCIT right now, and slowly phase that over to EDV/ZROZ over time. I think EDV/ZROZ are still a bit expensive given that they just spiked in March.
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