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Risk Parity Investing: A New Allocation Model Is Here

For the past 25 years, the asset allocation pie chart has been the most prominent and widely used tool in financial planning. Type in your age, some basic income and risk tolerance information and out comes a recommended formula for how much money you should have in stocks, bonds and cash.

In this installment of Investing 101, we take this methodology to the next level, with a look at Risk Parity Investing. Although it has existed for over 50 years, practitioners like Lee Partridge, the CIO of Salient Partners, says by attempting to smooth out returns, it is gaining converts by the day.

"At its core, risk parity does two things; it targets a specific level of risk, then it divides that risk equally across four component parts of the portfolio to achieve true diversification," Partridge says in the attached video. Compared to a plain vanilla stocks and bonds portfolio where he says a 60% allocation of stocks drives about 95% of the returns and volatility, a risk parity investor's holdings will look totally different.

"In order to achieve 25% risk from equities, you only need about 20% of your portfolio in stocks," Partridge says, "far less than what individual investors are accustomed to."

By targeting risk and specifically diversifying for different economic scenarios, the objective of this alternative method of investing is different from the outset. Partridge says the goal is to receive the same level of return with less risk and volatility OR to achieve higher returns with the same level of risk and volatility.

"The main reason there's such strong demand for risk parity investing is because investors have been disappointed in their other attempts to diversify their portfolios," he says. Whether it's alternative investments, market timing or active managers, most investors "have fallen short and their returns have been disappointing."

To be sure, risk parity is more complicated, thus harder to explain to customers than the the good old pie chart, but Partridge says by focusing on four core holdings --equities, credit (or even credit default swaps), interest rates and commodities-- investors become far "less susceptibility to negative market events," which is not a hard sell at all.

"Equities generally do well during times of positive growth and benign inflation," he explains, while "commodities do well in periods of rising inflation." Since the same type of variance also holds true for bonds and interest rates, he says you always have something in your portfolio that does well in a variety of growth, inflation and even sentiment scenarios.

Investors can purchase mutual funds that offer this strategy, including one from partridges own firm Salient (SRPFX) as well as several other reputable fund managers like AQR and Invesco (IVZ). In fact, Partridge says, individuals can capture most of the benefits of risk parity investing by simple putting 25% of their funds into four different ETFs that match its key asset classes, such as the S&P 500 SPDR (SPY), the iShares Corporate Bond ETF (LQD), a Treasury ETF (TLT) and a Commodity ETF (DCB).

By doing so, he says investors of all ages and levels on the risk scale can be in a ''perfectly diversified portfolio that's optimal" for all investors.