Here is the first installment of Michael Rulle’s white paper on Risk Parity. We will run the rest of the paper every day next week. Michael Rulle explains how a unique experiment into perception framing inspired the creation of a better portfolio strategy.
About 12 or 13 years ago, I was invited to a talk given by the famous Mathematics Professor and billionaire founder of Renaissance Technologies, James Simons. He told the audience that he was going to show us a two-minute film to “test our concentration”. The famous multi-billionaire Hedge Fund creator and Veblen Prize winner in Geometry was challenging his audience to concentrate.
What a set up.
He told us the film would have a group of six people with three basketballs. Our task was to simply count the number of times the basketballs were passed. The lights went out, the film comes on and I focused as much as possible on the passers. There were three males and three females, and they were in constant motion while randomly passing the basketballs to each other. It was very difficult to count the passes and did require great concentration. The film ends quickly and the lights in the auditorium come back on. He lets us wait about 20 seconds and then asked, “how many counted 38?” About 10% to 15% of the audience raised their hand. He congratulated those who got it right. Then he asked, “how many of you saw the man in the gorilla suit?” I recall only two people raising their hand. What?
He then proceeds to tell the audience that a man in a gorilla suit walked slowly into the middle of the group of passers, stopped to look at the camera, waved his hands several times over his head, slowly lowered his hands, and then sauntered out of the picture just before the passers stopped their activity.
I believed he was playing a trick on the audience. There was no way I thought a man in a gorilla suit was in that film. It was impossible. He then replayed the film. I was genuinely shocked; all I could see was the man in the gorilla suit. I immediately told my colleague “no way is that the same film, that’s the trick, seeing if we will believe anything told us by an authoritative figure.”
He then told us the background of the film. Professor Daniel Simons, with co-author Christopher Chabris, published research in 1999 conducted at Harvard University about “the Invisible Gorilla” (later a book was published, available on Amazon).A film is currently on YouTube with 10 million views -- but if you are reading this you will see the gorilla.
To this day that “trick” still astounds me. The obvious is often lurking just beyond our awareness. Simons’ comment about “testing our concentration” was a classic case of “perception framing”, (Tversky and Kahneman— “The Framing of Decisions and the Psychology of Choice” -- 1981). By intensely concentrating on what we were told was the point of the exercise, we were deceived as to what was the real point of the exercise. Those with strong concentration skills succeeded in what we were directed to follow but missed something much more obvious. By framing our perception, we concentrated intensely on the passes and ignored—literally the 500 pound gorilla. It is a metaphor for life and investing. It is a basis for the expression: "You can't see the forest for the trees.”
The Man in the Gorilla Suit – the 50/50 Risk Parity Portfolio
We call the two-asset class 50/50 risk weighted portfolio of Equities and Fixed Income (i.e., the two-asset class Risk Parity Portfolio) the “Man in the Gorilla Suit”. It is the most obvious portfolio investment that all have missed — certainly we have— and it has consistently outperformed what virtually all institutions have achieved. We missed it because we have instead followed the “perception framing” authoritative figures have told us to use. However, this became egregious when we simultaneously ignored more important issues. In very simple terms, we ignored the most basic rules of portfolio construction that all of us have learned in finance courses, i.e., the critical role of proper diversification, and the role of the “Tangency Portfolio” along the efficient frontier.
Risk Parity (dollar weights of portfolio constituents change inversely with the constituents’ expected volatility) is a concept which has existed since at least the early 1980s, although under different names. A 50/50 Risk Weighted Portfolio, i.e., Risk Parity, allocates “constant risk” (also called “target volatility”) equally to Equities and Treasuries (Fixed income), while also targeting volatility for the whole portfolio. Portfolio hedging techniques, designed to neutralize risk between two or more asset classes, go back to the earliest days of the over the counter derivatives markets.
Today, the term Risk Parity usually refers to a specific investment strategy that incorporates equities, Treasuries, and some combination of commodities and/or Treasury Inflation Protected Securities (TIPs). MSR Indices LLC, in partnership with S&P Dow Jones, helped create their family of Risk Parity Indices. This index applies equal risk weighting, not dollar weighting, to three major global asset classes: Equities, government notes, and commodities.
By averaging the risk, we create greater diversification and less risk. In coming posts, we will explain how investors can achieve this and provide data that backs this up.
Michael S. Rulle, Jr. is the founder and CEO of MSR Indices, LLC, a commodity trading advisor that offers an expansive range of index-tracking investment programs. This piece is an excerpt from a white paper titled: “The Gorilla in the Room: The obvious method of asset allocation most of us have never considered.”
Rulle inspired a family of indexes launched by S&P Dow Jones called S&P Risk Parity Indices, Rulle discussed Risk Parity at the 2019 TradersEXPO New York. Prior to founding MSR in 2015, he was president of Graham Capital Management, where he was directly responsible for the firm's discretionary portfolio managers.
