Risk Parity
Candlefocus EditorRisk parity attempts to balance investment risks in the portfolio by allocating capital to various asset classes in proportion to their risk. By distributing risk across different asset classes, the risk parity approach attempts to achieve higher returns with lower overall risk. In practice, this may involve using leverage and short positions to increase the overall riskiness of the portfolio.
Under a risk parity approach, the weight assigned to each asset class is determined by the level of risk that the asset class carries relative to the risk of the entire portfolio. The objective of risk parity is to create an optimal balance between risk and return, thereby reducing the amount of volatility within the portfolio.
Risk parity differs from MPT in several ways. Firstly, the risk parity approach incorporates leverage, which is not allowed in traditional portfolio construction. Secondly, risk parity is more dynamic and actively managed, meaning that the asset allocation may be frequently adjusted. Finally, whereas MPT seeks to optimize expected returns, the objective of risk parity is to minimize risk.
Due to its sophisticated quantitative calculations, risk parity is generally seen as a more advanced approach to portfolio construction compared to simpler strategies. Still, this approach may not be suitable for all kinds of investors, as leverage and short positions can increase risk. Investors should be sure to understand the risks associated with this approach before implementing it.