Risk Parity and the Four Faces of Risk

Benjamin Graham famously said that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” But this is not quite correct. Rather, in the short term, the market is a machine where investors “vote” about what the market will “weigh” in the future. Of course, when Benjamin Graham referred to “weighing,” he was actually referring to how investors “value” an asset.

The goal of this article is to summarize the complex dynamics that drive asset returns. You’ll discover that asset returns are impacted by four sources of risk. Two of these risks affect all assets in the same way, and therefore are undiversifiable. The other two risks impact different kinds of assets in different ways. Since some assets respond positively to changes in these risks while others react negatively, these latter two risks can be diversified away. In other words, investors who take an informed view of diversification can almost eliminate fully half of the sources of risk in their portfolio.

Prices always reflect investor expectations

Before investigating the four sources of risk, it’s important to understand that markets are constantly adjusting prices to reflect investor expectations about the future. As a result, meaningful changes in prices will only occur if investors receive new information that is inconsistent with current expectations. When this happens, investors experience a shock, which causes them to adjust the price of assets higher or lower to reflect this new reality.

To make this concept more concrete, imagine that investors are currently expecting a poor environment for a certain asset. To reflect these pessimistic expectations, investors will have acted accordingly to lower the price of the asset. If the future environment is unfavorable for the asset, the price of the asset should not change. That’s because investors have already priced the asset appropriately for an unfavorable future. The price of the asset will only be reset higher or lower if investors receive new information that causes a meaningful change in expectations.

To summarize this critical point, asset prices do not change in response to favorable or unfavorable environments. Rather, asset prices reflect investors’ current expectations about a favorable or unfavorable environment. Prices will only experience meaningful change if investors receive new information that represents a shock to their current expectations.

Asset classes

Asset classes refer to the broadest categories of financial assets. Few investors think about investing from this perspective, but in fact most of the important things that happen in markets are driven by what happens at the asset class level.

When we refer to asset classes, we are talking about global stocks, bonds, currencies, commodities, inflation protected securities, and traded real-estate. These asset class categories have very different underlying mechanics, which cause them to react in different directions to certain types of shocks. In other words, a given shock may cause stocks to be repriced in one direction while bonds are repriced in the opposite direction.