What Is Risk Parity?

1921 Words Jun 1st, 2016 8 Pages
What is risk parity?

The biggest challenge investors face today is a low return environment. The returns on assets are low and the risks are high. In a traditional 60/40 portfolio almost all of the risk comes from equities. Equity risk accounts for 90% of the risk of the portfolio, which is significantly higher than its 60% weight. This creates a problem because volatility in the portfolio is now almost entirely dependent on what happens in equities, making the portfolio much less diverse than investors believe. This lack of diversity has caused investors to take on unnecessary risk to get the same return. Risk parity provides a solution to this issue.
Risk parity is an asset management strategy that seeks to balance portfolios based on risk between asset classes. It defines a well-diversified portfolio as one where all asset classes have the same marginal contribution to the risk of the portfolio. By balancing a portfolios risk exposure the portfolio can hedge against changing market conditions in order to capitalize purely on beta return. To do this risk parity funds leverage up until the risk of bonds is equal to the risk of stocks. For example, if a fund has stocks with a standard deviation of 12 and bonds with a standard deviation of 4, the firm will leverage the portfolio until the risk from bonds is equal to the risk from stocks. Giving them a balanced portfolio. This strategy allows investors to have an even better risk-to-return ratio because it diversifies even…
Open Document