Understanding Risk Parity, Strategies & Example

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Risk Parity is an investment strategy that allocates risk rather than capital among different asset classes.

Table of Contents

What Is Risk Parity?

Risk Parity portfolios rely on risk-based diversification, seeking to
generate both higher and more consistent returns, the key to Risk Parity is to diversify across asset classes that behave differently across economic environments.
Risk Parity

Understanding Risk Parity

Risk Parity portfolios rely on risk-based diversification, seeking to generate both higher and more consistent returns. (More diversified portfolios have higher Sharpe Ratios.) The typical Risk Parity portfolio begins with a much lower exposure to equities relative to traditional portfolios and invests significantly more in other asset classes.

 

As a result, the risk budget of the portfolio is not concentrated in equities,
but spread more evenly across other asset classes.

 

The key to Risk Parity is to diversify across asset classes that behave differently across economic environments. Equities generally do well in high growth and low inflation environments, bonds do well in deflationary or recessionary environments, and commodities tend to perform best during inflationary environments. Having balanced exposure to these three main asset classes can produce more consistent long-term results.
 

While there can be material differences among Risk Parity strategies, such as the breadth of asset classes used and portfolio construction methodologies employed, the concept that binds them all is a more balanced approach to risk allocation.

Constructing A Simple Risk Parity Strategy

“Risk Parity” by definition aims for equal risk across asset classes, and for this study, we will target a similar amount of volatility from each asset class every month. In order to do this, we begin by determining the expected volatility for each asset class.
 
For illustrative purposes only

The position weight calculated at the beginning of each month then is simply the targeted annualized volatility for each asset class divided by the forecasted volatility for that asset class. We repeat this process each month and rebalance to the new weights.

 

For comparison purposes, we scale the portfolio so that the average annualized volatility of this portfolio matches the volatility of the 60/40 portfolio over the period.

 

 

This methodology ensures that a lot less capital is allocated to high volatility asset classes (e.g., equities). As a result, these risks will not dominate the portfolio since exposures to lower volatility assets are increased to balance risks. As volatility estimates change, the holdings of Risky Parity portfolios also shift accordingly to maintain the desired diversification.
For illustrative purposes only: Risk Parity Portfolios can Offer Higher Returns with Less Concentration Risk

The Bottom Line

The theory and practice behind Risk Parity strategies have gained
increasing ground with investors because of:
 
  • Reduced equity concentration and reduced tail risk,
  • More meaningful diversification than traditional approaches,
  • A portfolio that is more robust in different economic environments, and
  • An opportunity to improve the risk/return characteristics of an overall portfolio, by either enhancing return, reducing risk, or a combination of both.
These potential advantages of Risk Parity have led to increased acceptance of the approach among large institutional investors.

As the approach becomes more widely available, it deserves consideration by any investor seeking to build more efficient portfolios.
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