Risk parity refers to a strategy of portfolio allocation that determines allocations using risk, across all the different components of the investment portfolio. It utilises an approach to investing known as MPT, or the modern portfolio theory. An overview of MPT can be seen in the embedded PDF. The risk parity investment strategy was popularised by Ray Dalio of Bridgewater Associates, who is known as the pioneer of risk parity and alpha/beta separation. Thibaut de Roux has worked in risk management for almost three decades, exploring the alchemy and volatility of risk. The risk parity approach to investing seeks to allocate funds to a broader range of categories than in a traditional portfolio setup to maximise gains through equalising risk.
Traditional Portfolio Allocations
Traditionally, a balanced investment portfolio would contain 60% stocks and 40% bonds. In this type of allocation, the stocks carry 90% of the total risk. The aim of this method is to standardise exposure and diversification within the portfolio. Typically, within a standardised portfolio with this type of simplified allocation strategy, the investor will weight the portfolio more heavily towards equities the more willing they are to take on risk. Investors who are more risk averse and interested in preserving their capital will weight their portfolio more heavily with bonds.
Risk Parity Percentages
Portfolio allocation is not a straightforward calculation as different types of investments offer different levels of risk and reward. A portfolio divided equally into 50% equities and 50% bonds might sound balanced, but it is not. Equities carry more risk than bonds and bonds offer about half the return of equities in the long term. So, a portfolio divided equally into two actually has a risk allocation of about 70/30, not 50/50. A portfolio that equalises the risk allocation to 50/50, however, will look something like 35% equity and 65% bonds. In this type of portfolio, the risk is equalised, but the returns will be low. A risk parity strategy aims to solve this problem by leveraging the bonds, possibly through bond futures, to create a parity in terms of volatility between the fixed income and equity sides of the portfolio.
Managing a Risk Parity Portfolio
A risk parity strategy for portfolio management is not for everyone as it can require strong management. More hands-off investors may want to consider a different type of strategy. Some other strategies for portfolio protection are outlined in the infographic attachment to this post. Funds in a risk parity portfolio are allocated across more varied asset classes, including real estate, commodities, real assets, credit-related securities and inflation-protected bonds, as well as government bonds and traditional stocks. The leverage required for a risk parity portfolio has the potential to produce negative consequences without proper management, so continuous oversight can be essential. However, there are some who view risk parity portfolios as a relatively passive approach to investment, as the investor does not have to make judgements about the future behaviour of the markets.
Risk parity strategies for investment portfolios and investment funds allow for alternative diversification. A definition of portfolio diversification can be viewed in the short video attachment. This is because portfolio or fund managers are not limited to choosing stocks and bonds but can utilise any mixture of assets to achieve the desired balance. The optimal risk target level is used as the fundamental basis for making investment decisions. Leverage is used to weight the risk so that it is balanced across all the asset classes featured in the portfolio.