Articles on investing and capital management, with a quantitative focus.

#prp - Permanent Risk Parity (how I invest)

Updated PRP Allocations


I made a small change to my PRP allocations. The new targets are:

Weight Asset class Change
40% Stocks +10%
40% Bonds -10%
20% Gold none

This is the first change to my asset allocation in 7 years. PRP continues to be a risk parity portfolio which is similar to the Permanent Portfolio.

The recent outperformance of stocks has drifted my allocations close to my new targets, so I don't plan to sell any bonds.

There are a few reasons for this change:

More Equity Risk

When I started using the Permanent Portfolio / PRP, I knew that it was overly conservative, but I really wanted portfolio stability. I was invested during both the 2001 and 2008 bear markets, and remember the experience. I was not a disciplined or systematic investor back then (unfortunately) but the extreme volatility of stocks caused me stress.

When deciding on my PRP allocation, I didn't want to "bite off more than I can chew". Guided by risk parity math, I started at a very conservative 30% stocks.

In recent years, I experienced a few episodes of market volatility (2018, 2020, 2022) which helped calibrate my comfort level. I now feel comfortable taking a bit more equity risk, so I am dialling up the equity risk by one step, to 40% stocks.

New Kind of Pain

When I went through risk parity portfolio design and optimization, I relied heavily on two risk metrics:

The idea behind this kind of optimization is that volatility and drawdowns both translate into pain and suffering. And indeed they do! Running this kind of optimization results in a portfolio that is light on stocks, and heavy in bonds or fixed income.

The Federal Reserve and Bank of Canada introduced me to a new kind of pain that wasn’t in my models: high inflation, and real drawdowns (after inflation).

I always knew that bonds were vulnerable to inflation (since they have poor real returns), but I didn’t realize how painful that effect could be.

Because bonds tend to have poor real returns in high inflation, a bond-heavy portfolio experiences a worse real drawdown. This effect can be seen in a comparison of my old and new allocations, using the excellent testfolio tool. This comparison begins in 2020 and is adjusted for inflation.

Note that the old allocation (heavier in bonds) had a worse real drawdown, and a longer-lasting drawdown. The new allocation has a shallower drawdown and faster recovery.

Stocks and gold performed quite well during the last few years of high inflation. One has to be careful about recency bias, but I think it's fair to say that stocks generally fare better than bonds during high inflation. Recent research by Cederburg and others supports this, and points to particularly bad outcomes from bonds when there is high inflation.

It's also possible for high inflation periods to play out differently, so 2020-2024 should not be taken as a template for asset class behaviour. Perhaps it's best to view the last few years as a reminder that bonds have significant inflation risk. Slightly reducing my bond allocation will help to address this.

Jem Berkes