Risk parity is a type of asset allocation strategy that has become increasingly popular in the aftermath of the global financial crisis. Risk parity strategy evens out the risk contribution of each asset class within portfolio.
Risk parity strategy can be summarized as portfolio management strategy which seeks equal risk contribution from each asset class which results into more fund allocation to assets with lower risk.
Why Risk Parity Strategy? In investment world it is commonly said “Higher the Risk Higher the returns”. Any portfolio strategy targets to maximize the profit of investors by investing more into riskier portfolios as compared to less risky portfolio. E.G. one of the traditional portfolio allocation strategies is 60/40 where 60% of funds are allocated to equities and 40% of the funds are allocated to debt (Bonds) because equities being risker results into higher returns.
The traditional portfolio allocation did not fare well during the 2008 financial crisis, as equities dropped dramatically during the period’s heightened volatility. Risk parity avoids this concentration of risk in equities.
How Risk Parity Strategy works? The rationale behind risk parity is intuitive and noble.
Why intuitive? Let us understand while taking analogy from another strategy known as All Weather Strategy. The idea for All Weather is simple: Different economic scenarios pose risks to different asset classes throughout the business cycle. If our portfolio has enough diversification or better to say a optimized diversification then at least a part of the portfolio could weather each risk of economic downturn.
So this is where the All Weather is similar to risk parity: Instead of targeting optimal risk and return in the traditional portfolio optimization setting, both strategies strive to achieve balanced risk contributions from all asset classes.
Basically, rather than targeting predetermined risk and return from a portfolio these two strategies try to optimize the contribution from each asset class to better equip strategy during economic downturn.
Shortcoming of Risk Parity Strategy: Investors who do not fully understand risk parity strategies often are concerned that the strategy’s higher exposures to fixed income will cause it to under perform traditional portfolios with more equity exposures over the long run.
Let us understand with the help of an example.
Strategy 1: Traditional portfolio like 60-40 has 60% allocation to equities and 40% allocation to debt.
Strategy2: Based on historical data we realized variance (Variance or Standard deviation are generally referred as risk in financial world) in historical return of equities is 60% where are variance in historical return for debt (Bonds) is 40%.
To make equal contribution of 50% towards overall risk of portfolio; we have to invest more into debt in comparison to equities.
Clearly strategy-1 will give more returns in comparison to strategy-2 but it would also have more chances of higher losses during economic downturn.
Solution to Lower Returns: If investors are ready to use leverage (Loans for investing or financing) then above shortcoming of lower returns can be tackled. A very famous model for asset management CAPM (Capital Asset Pricing Model) allows for that, the levered-up risk parity portfolio should earn higher returns than traditional portfolios at similar risk level, or lower risk at similar return levels.
Final notes: In summary, risk parity is an asset allocation strategy in which each asset class contributes more or less equally to portfolio risk. Leverage is an essential element of the strategy, although for a variety of reasons many investors are not able to use leverage. Risk parity does not guarantee out performance vs. more traditional “efficient” portfolios, though it can deliver better risk-adjusted return over the very long run.
In the next section we would cover Risk Parity strategy using python.