Risk Parity
Quick Definition
A portfolio strategy that equalizes each asset class's risk contribution rather than capital allocation, often using leverage on low-risk assets.
What Is Risk Parity?
What Is Risk Parity?
Risk parity is a portfolio construction approach that allocates based on equal risk contribution from each asset class, rather than equal capital allocation. Popularized by Ray Dalio's Bridgewater Associates through the All Weather Fund, risk parity aims to create truly balanced portfolios across different economic environments.
Risk Parity vs. Traditional Allocation
| Metric | 60/40 Portfolio | Risk Parity Portfolio |
|---|---|---|
| Stock allocation | 60% | ~25% |
| Bond allocation | 40% | ~55% |
| Commodities | 0% | ~10% |
| TIPS | 0% | ~10% |
| Stock risk contribution | ~90% | ~25% |
| Bond risk contribution | ~10% | ~25% |
| Leverage | None | Often 1.5-2x |
How It Works
- Identify asset classes: Stocks, bonds, commodities, inflation-linked bonds
- Measure each asset's volatility: Stocks ~16%, Bonds ~5%, Commodities ~20%
- Equalize risk contributions: Lower-volatility assets get higher capital weight
- Apply leverage (optional): Lever up the entire portfolio to achieve target return
- Rebalance regularly: Maintain equal risk contributions as volatilities change
Example Calculation
Target: Equal risk from stocks and bonds
- Stocks volatility: 16% | Bonds volatility: 5%
- To equalize: Bond weight / Stock weight = 16/5 = 3.2x
- Result: ~24% stocks, ~76% bonds (unlevered)
- With 1.5x leverage: ~36% stocks, ~114% bonds (using borrowed capital for bonds)
Performance Characteristics
- Lower drawdowns in equity bear markets (2008: risk parity fell ~15% vs. ~35% for 60/40)
- Better risk-adjusted returns historically (higher Sharpe ratio)
- Vulnerable to rising rates: Heavy bond allocation suffers when rates rise (2022 challenge)
- Requires leverage: Unlevered risk parity has lower absolute returns
Why It Matters
Risk parity challenges the assumption that a "balanced" portfolio is balanced by dollars. A 60/40 portfolio gets 90% of its risk from stocks. Risk parity creates true balance, performing more consistently across growth, recession, inflation, and deflation environments.
Formula
Formula
Risk Contribution_i = w_i × (Σw)_i / σ_portfolioRisk Parity Example
- 1Allocating 25% stocks and 55% bonds so each contributes equally to total portfolio risk
- 2Bridgewater's All Weather Fund using risk parity across growth, inflation, and deflation assets
Related Terms
All-Weather Portfolio
A portfolio strategy designed by Ray Dalio to perform reasonably well across all economic environments using risk parity principles.
Risk Budgeting
A portfolio construction method that allocates a total risk budget across assets or strategies, ensuring each contributes a defined amount of risk.
Asset Allocation
The process of dividing investments among different asset classes like stocks, bonds, and cash to balance risk and reward.
Modern Portfolio Theory (MPT)
A framework developed by Harry Markowitz showing how investors can construct portfolios to maximize expected return for a given level of risk.
Rebalancing
The process of realigning portfolio weights by buying or selling assets to maintain the original desired asset allocation.
Efficient Frontier
The set of optimal portfolios that offer the highest expected return for each level of risk, forming a curve on a risk-return graph.
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