What Is Risk Parity?
Let me explain risk parity directly: it's a portfolio allocation strategy where you determine how to spread your investments across different components based on their risk levels. This approach tweaks the classic modern portfolio theory, or MPT, by introducing leverage into the mix.
With MPT, you're looking to diversify your portfolio among specific assets to maximize returns while sticking to certain market risk guidelines, considering the whole portfolio's risk and returns—but only with long positions without margin. Risk parity takes this further by calculating precise proportions of capital for each asset class, helping you achieve the diversification that fits your goals and preferences.
Understanding Risk Parity
At its core, risk parity aims to allocate your investment capital on a risk-weighted basis, optimizing diversification by viewing the entire portfolio's risk and return as a unified whole. This method expands on MPT but permits leverage and short selling, making it more sophisticated.
You'll find risk parity used often by hedge funds and experienced investors because it demands complex quantitative calculations—far more advanced than basic allocation strategies. The objective here is straightforward: earn the best possible return for your chosen risk level.
Think about simple strategies like a 60/40 split between stocks and bonds; they rely on MPT to balance expected returns against risk. More aggressive investors tilt toward stocks, while conservative ones favor bonds for preservation. But risk parity lets you incorporate leverage, alternative assets, and short selling, basing everything on your target risk rather than fixed asset classes.
Risk Parity Methods
In practice, a risk parity strategy typically involves stocks and bonds, but instead of preset ratios like 60/40, you set proportions based on your desired risk and return targets. This evolves from MPT, allowing you to target specific risk levels and spread that risk evenly across your portfolio for superior diversification.
Another key element is the security market line, or SML, which graphs the relationship between an asset's risk and return as part of the capital asset pricing model. The line slopes upward, showing higher potential returns come with higher risks, with the slope tied to market beta.
There's an assumption that this slope stays constant, but in reality, it might not. For traditional allocations, you often need to take on more risk for decent returns, limiting diversification as you add riskier equities. Risk parity addresses this by using leverage to balance volatility and risk across all assets in your portfolio.
Real World Examples of Risk Parity
To see this in action, consider the AQR Risk Parity Fund, which invests worldwide in stocks, bonds, currencies, and commodities, balancing risks through parity to pursue optimal returns.
Similarly, Horizon's Global Risk Parity ETF applies an equal risk-weighted volatility approach to decide capital allocation, ensuring balanced participation across assets.
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