The three pillars of diversification
Every risk parity portfolio pairs an equity sleeve with three distinct diversifiers, each serving a different economic function. They don't all win at the same time — that's the point. When one fails, another picks up the slack.
When the economy contracts, central banks cut interest rates to stimulate growth. Falling interest rates push bond prices up — especially long-duration bonds, which are most sensitive to rate changes. This is why long bonds historically rise when stocks fall in recessions.
In the 2008 financial crisis, long Treasury bonds (TLT) gained roughly 25% while the S&P 500 fell 37%. That's the cushion at work. A portfolio with 25% long bonds absorbed a meaningful portion of the equity shock and provided rebalancing capital to buy equities at depressed prices.
The catch: long bonds fail catastrophically in inflationary regimes. When rates rise (as they did aggressively in 2022), bond prices fall hard. This is why bonds alone aren't enough — you need gold and managed futures to cover the inflation quadrant.
Gold's reputation as a "doomsday prepper" asset does it a disservice. In risk parity construction, it's simply a diversifier — an asset with low long-term correlation to stocks that performs well in the environments bonds don't.
Gold thrives when confidence in financial assets erodes: during inflation (because governments can't print it), during currency crises, during geopolitical uncertainty, and during periods when real interest rates are negative (interest rates minus inflation). It's a 5,000-year store of value for a reason.
In portfolios like the Permanent Portfolio and Golden Ratio, gold holds 16–25% precisely because it covers the regime that bonds can't: sustained inflation. In 2022, while bonds fell 25-30% and stocks fell 20%, gold was roughly flat — a meaningful outperformance that reduced overall portfolio drawdown.
Don't hold gold because you think the financial system is collapsing. Hold it because it's uncorrelated with stocks and bonds over long periods and provides inflation protection.
Managed futures funds take long and short positions across multiple asset classes simultaneously — commodities, currencies, interest rates, and equities — following whichever trends are strongest at any given time. If commodity prices are rising, the fund goes long commodities. If bond prices are falling (rates rising), the fund goes short bonds.
This makes managed futures the most genuinely uncorrelated diversifier available to retail investors. Unlike gold and bonds, which have specific regimes where they shine, managed futures can profit from any sustained trend — including sustained downtrends in stocks or bonds.
The 2022 performance is the most cited example: DBMF gained approximately 22%, KMLM gained approximately 30%, while the rest of the portfolio was falling. The fund was short bonds (rates rising trend) and long energy (inflation trend) — both of which paid off dramatically.
One fund is enough — don't chase performance between DBMF and KMLM. They use similar strategies and the diversification benefit of holding both is limited. Consistency of allocation matters more than which specific fund you choose.
Why you need all three
Each diversifier has a failure mode. The reason risk parity portfolios hold all three is that no single diversifier covers every dangerous environment.
- Bonds fail in inflation — gold and managed futures cover this
- Gold fails in deflationary growth — bonds provide deflation protection
- Managed futures can have multi-year flat periods — bonds and gold smooth returns during trend-following droughts
- All three underperform stocks in bull markets — the equity sleeve handles this
The result is that something is always doing its job. Not always brilliantly — but well enough that no single environment can destroy the portfolio. That's the goal.
Holding both DBMF and KMLM at small allocations likely gives you complexity without meaningful additional benefit. Similar strategies, similar exposures. One fund, held consistently, is enough.
What about crypto?
Bitcoin and other cryptocurrencies are sometimes proposed as a sixth diversifier. Cryptocurrency is not a good portfolio diversifier because it has demonstrated high correlation with tech stocks — particularly large cap growth equities — during market stress.
In drawdowns, crypto tends to fall alongside or more severely than growth equities. It doesn't provide meaningful cushion in the environments where cushion matters most. It may have positive expected return, but positive return doesn't make something a good diversifier. Correlation properties matter more than expected return when selecting assets to pair with equities.