The concept of risk-parity started to gain significant traction from the 1990s onwards, with the launch of a fund by one of the worlds largest hedge funds, Bridgewater Associates. The naming of this investment methodology as risk parity though was actually coined later in 2005.
So, what is risk-parity
Risk-parity is a method to ensure each asset class in your portfolio has a balanced contribution to your overall portfolio risk. It is more applicable for investors with a broad and diverse set of asset classes in their overall portfolio than an investor who solely invests in equities. However, we wanted to write a small post on risk-parity due to its prevalence online.
As an investment method, risk-parity decides the asset allocation within a portfolio using volatility rather than a percentage of capital. We discussed the concept of a risk budget previously and risk-parity ties in quite closely with that overall concept.
If an investor says I want to have 60% stocks and 40% bonds in my portfolio, the actual contribution of stocks and bonds to their portfolio volatility is very different, with up to 90% of their volatility being driven by their equity allocation.
Pie charts showing the asset % allocation versus the portfolio volatility
If the investor wants to follow a true risk-parity approach, then they would in fact leverage up the bond allocation within their portfolio to ensure that its contribution to the portfolio risk was the same as the stock portfolios. This means that instead of a 90%/10% split the investor would have a 50%/50% volatility contribution split. There are various methods of leverage available for investors to deploy (futures contracts or repurchase agreements but these are beyond the scope of this small post).