Bond ETFs as a means to achieve risk parity
Background
One of the investors that I really look up to is Ray Dalio. He has stated that a 50/50 stock to bonds allocation does not achieve risk parity because 80% of your risk is still in your stocks. Digging deeper into how one can achieve the risk parity that Dalio has described I found this article where he actually outlines the following asset allocation mix that will provide the average investor with diversified risk.
30% - Stocks
40% - Long Term Treasury Bonds
15% - Intermediate Term Treasury
7.5% - Commodities
7.5% - Gold
I've started looking into how I can responsibly invest in these asset classes, and it's the bond investment that I don't really understand.
For the long term treasury bonds I'm considering the Vanguard Extended Duration Treasury ETF (EDV). However, the risk potential is reportedly very high.
In comparison, the Vanguard Total Stock Market ETF (VTI) reportedly has less risk.
Given all that context, I'll finally throw out some questions.
Questions
How is it possible that long term treasury bonds, which the government has never defaulted on, can hold more risk as an ETF than the stock market index?
Do you assume more risk investing in bond ETFs than you would investing in individual bonds?
Are bond ETFs an appropriate investment vehicle for risk diversification?
(2)2 Comments
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This is an old question that has been bumped because of an edit, but there's one point that I think was overlooked:
The "high risk" you're seeing for a bond ETF is comparing the risk of that ETF to other ETFs in the same investment class. So its risk (and average return) is high compared to other bond ETFs, but will most likely be less than the risk of equity ETFs (as will the returns).
NL's explanation of the nature of that risk (interest rate risk vs default risk) is spot on.
How is it possible that long term treasury bonds, which the government has never defaulted on, can hold more risk as an ETF then the stock market index?
The risk from long-term bonds isn't that the government defaults, but that interest rates go up before you get paid, so investors want bonds issued more recently at higher interest rates, rather than your older bonds that pay at a lower rate (so the price for your bonds goes down). This is usually caused by higher inflation rates which reduce the value of the interest that you will be paid.
Do you assume more risk investing in bond ETFs than you would investing in individual bonds?
If you are choosing the right ETFs, there should be a lower amount of risk because the ETFs are taking care of the difficult work of buying a variety of bonds.
Are bond ETFs an appropriate investment vehicle for risk diversification?
Yes, if you are investing in bonds, exchange traded funds are an appropriate way to buy them. The markets for ETFs are usually very liquid.
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