Before we dive into a discussion of Ray Dalio’s famous All-Weather Portfolio, even seasoned investors may benefit from a reminder about strategic asset allocation – and how risk parity, a technique pioneered by Bridgewater Associates, aims to improve upon traditional versions of this. ⚖️

Strategic asset allocation involves building a portfolio based on target allocations for different asset classes, and then rebalancing that portfolio regularly to make sure it stays that way. One well-known allocation is the “60/40 portfolio” – where an investor places 60% of their portfolio in stocks and 40% in bonds. A year later, stocks may have performed well but bonds declined – causing the portfolio’s value to skew 65% stocks and 35% bonds. Since that’s a deviation from their initial targets, the investor will then sell stocks and buy bonds to bring the whole portfolio back to a 60/40 split. So far, so simple. But how – and why – is such a mix determined in the first place?

The general idea is to have an allocation that provides a certain balance between risk and return over a long time horizon, tailored to the investor’s goals and therefore their risk tolerance. For example, a young individual saving for long-off retirement can afford to take on more risk – allocating a higher proportion to stocks because, while volatile in the short run, they also offer the highest long-term expected return. An individual very close to retirement, on the other hand, can’t afford to take on loads of risk – and so might lean more towards safer government bonds.

Dalio is a big proponent of strategic asset allocation: it fits in nicely with many of his investment principles. As well as supporting diversification, especially across different asset classes, strategic asset allocation is an investing strategy that tries to capture long-term market cycles. It also shuns bias. For example, some investors might avoid shares after a big stock market crash but in retrospect, that would probably have been the most opportune time to buy stocks. Strategic asset allocation, with its constant weighting to different asset classes, is an inherently open-minded strategy that makes sure you’re invested during both good times and bad – and that tends to pay off in the long run. 🎉

As Dalio himself puts it:

"The most important thing you can have is an excellent strategic asset allocation mix. In other words, you're not going to win by trying to get what the next tip is – what's going to be good and what's going to be bad. You're definitely going to lose. So what the investor needs to do is have a balanced, structured portfolio – a portfolio that does well in different environments." – Ray Dalio

One of strategic asset allocation’s benefits, in other words, is that it’s diversified across different asset classes that tend not to move in lockstep – both reducing risk and allowing a portfolio to hold up well in different environments. Infrequent rebalancing, meanwhile, means less wasted money on trading fees and better tax treatment. Strategic asset allocation is designed as a hands-off approach that doesn’t require massive amounts of time and resources. As a buy-and-hold strategy, it reduces the human error of trying to time the market or letting emotions interfere with investment decisions. And best of all, the technique can be easily implemented using exchange-traded funds (ETFs) that track broad asset classes such as stocks, government bonds, corporate bonds, commodities, and so on. ✅

One of the main criticisms of strategic asset allocation, however, is that it’s too focused on arbitrary capital allocation rather than risk allocation. A typical 60/40 portfolio, for example, splits money between two types of investment that don’t tend to move in the same direction. But the problem is that stocks are a lot more volatile than bonds, and a 60/40 mix means the bulk of a portfolio’s risk is coming from stocks’ piece of the pie – as illustrated below.

While you might think a 60/40 strategy delivers a well-diversified portfolio, in reality its performance will closely follow that of the stock market. That’s the problem risk parity – a technique pioneered by Dalio’s Bridgewater Associates – is trying to solve. The aim of a risk parity portfolio is to set the asset class weightings such that the contribution to overall portfolio risk from each asset class is the same – as illustrated below. In practice, this means lower exposure to stocks than traditional portfolios (due to their higher volatility) and more exposure to bonds.

Not only did Dalio pioneer the risk parity approach, but Bridgewater Associates also created the first risk parity fund: the All-Weather Portfolio. More on that next... ⚡

The takeaway: Strategic asset allocation is a sensible investment strategy, albeit one which aims to divide cash rather than risk – and that's the problem Dalio’s risk parity approach seeks to solve.