Complete Guide to Risk Parity

What’s on your bucket list?

Skydiving? Bungee jumping? Test driving a Ferrari?

For many, a good investment portfolio is their gold at the end of the rainbow. Such a portfolio can be very difficult to create under the best circumstances and can appear near impossible with all of the unexpected turbulence in the stock market. 📊

Risk parity is a portfolio-building strategy that aims to keep your portfolio safe even under the worst of circumstances—while still fully exploiting the good times—so you can do everything from your bucket list.

This approach proved its worth in 2008 when it outperformed most of its peers so it certainly isn’t something to scoff at. We’ll dive into its inner workings, and identify the likelihood of it repeating its previous success.

Ready? Let’s go! 👇

The Definition of Risk Parity 📚

Risk parity is an investment strategy that aims to equalize risk levels of all the components of a portfolio using advanced management, short selling, and leverage. Risk parity is derived from the modern portfolio theory but has several key differences.

This type of portfolio building gained traction throughout the first decade of the 21st century as it generally outperformed other strategies during the 2008 crash. Risk parity is particularly popular among hedge funds and sophisticated investors as it requires a higher level of active management.

Risk parity gets its name from the fact that, unlike most other allocation strategies, it doesn’t consider the allocation of capital within a portfolio, but focuses on the allocation of risk. Successful implementation of risk parity has two key components:

• ☑ The risk-adjusted returns of low-risk investments have to be greater than the risk-adjusted returns of high-risk assets;
• ☑ The cost of leveraging desired assets has to be low enough that sufficient profit can be achieved.

A common feature of risk parity portfolios is a good Sharpe ratio—a metric that often clearly illuminates the differences between investment mayflies and the true blue-chip-worthy mainstays.

Understanding How Risk Parity Works 👨‍🏫

There are several layers to understanding how risk parity works. While it is deceptively simple at a glance, it builds upon the modern portfolio theory and uses both diversification and some advanced investment methods. Lastly, unlike its competitors, it weighs heavily the risk of every element of a diversified portfolio.

The Role of Diversification 📃

A portfolio adhering to the modern portfolio theory—so, most contemporary portfolios—would be built with a lot of diversification in mind. The basic idea behind diversification is that different asset types behave differently under different circumstances.

A bare-bones expression of this thinking is using equities to garner growth for a portfolio and mixing them with bonds to lock in any profits. Essentially, equities like stocks are somewhat high-risk and high-reward while bonds aren’t likely to bring a lot of profit, but shouldn’t lose an investor money either.

This has given rise to several common maxims in portfolio building, like the famous 60/40 allocation. With the 60/40 allocation, an investor would have 60% of their portfolio invested in stocks, and 40% in bonds. Another common allocation principle is subtracting the investor’s age from 100 to get a good ratio.

Essentially, an investor who is 25 would hold 75% stocks and 25% bonds, while a 60-year-old would keep only 40% in equities and the rest in bonds. However, diversification doesn’t have to stop with stocks and bonds since both stocks and bonds can vary widely in their performance.

While bonds are generally considered low-risk, junk bonds—that can make you more money but are more likely to default—also exist. Additionally, while stocks of luxury goods companies can relatively safely be expected to suffer during a bear market, firms that provide essential goods and services are likely always to do reasonably well.

Still, it is important to remember that what is essential for human life and what isn’t can change dramatically over the years. For example, while electronics like smartphones might appear to be a luxury good, they just might end up being considered completely essential soon. A hint of such a possibility lies in the fact that the UN started considering internet access a basic human right back in 2016.

Additionally, bonds aren’t entirely stable either. Under the right circumstances, they can both experience periods of sizable growth, and troubling losses. Notably. bonds tend to become painful losers whenever the FED raises interest rates—like during the spring of 2022.

The Role of Risk 📄

In a more traditional portfolio build, most of the risk would be concentrated in the equities portion. For example, while 40% of a standard 60/40 portfolio consists of bonds, those low-risk assets tend to account for only about 10% of volatility.

A risk parity portfolio throws such an allocation away and seeks to equalize the risk contribution of every asset class. In a nutshell, if the risk of a 40/60 portfolio totals 10% with bonds accounting only for 1% of that number, a risk parity approach would reshuffle the composition so that the contributions of both classes are 5%.

This can lead to dramatic changes in proportion. For example, such a shuffle could bring the stock ratio down to just 10-15%. Balancing the portfolio allocation using risk parity tends to significantly reduce its volatility while marginally improving performance.

However, a portfolio altered like this still leaves room for improvement. Returns can be further increased using leverage—however, this method also increases the overall volatility. Generally speaking, the amount of leverage used will depend on your risk tolerance—but should generally be safe as long as the overall investments remain within the efficient frontier.

For the sake of painting a clearer picture, let’s take our previous 60/40 portfolio and say it has a risk level of 10%, and a return rate of 15%. Using risk parity, an investor would often find they’ve brought the risk down to 5% and increased the return rate to 15.2%. So, the result would be a significant improvement in terms of risk and marginally better returns.

Applying leverage to the investments—if done correctly—can raise the risk to the previous 10%, but also increase the returns to 20-30%. Ultimately, results like these are behind the rising popularity of risk parity. Keeping volatility low and the returns high is always good but is almost mandatory when the everything bubble appears to finally be deflating.

The Role of Leverage 📜

In a nutshell, when an investor leverages an asset, they are in fact borrowing money to increase the value of their investments. Two broad categories of leverage are used for risk parity—regular leverage and margin.

Leverage, as we’ve established, simply means borrowing money to buy securities. This is generally done to amplify the returns. Purchasing 10,000 shares that go up in value by $20 each is way more profitable than purchasing 100.

Margin has the same goals, but has some technical differences. Margin utilizes existing capital and assets as collateral in order to borrow funds from a broker at a fixed rate. Margin is also used to increase the potential value of an investment. For example, using margin can allow you to buy $10,000 worth of stocks for just $1,000 of your own money.

Both kinds of leverage have some severe drawbacks. On the one hand, they allow an investor to amplify their gains on an investment, but if the trade goes sour, they have the potential to make catastrophic losses. 

For example, imagine Tesla has shares worth $100 each, and an investor has $1,000 to spend. They could simply use the money they have and acquire 10 shares, or they could leverage the investment and get 100 shares.

If the stock price of $TSLA goes up by 10% the regular investment would have made the investor $100, but the leveraged one as much as $1,000. On the other hand, if the value goes down by $15 per share, an unleveraged trade would cost them $150, but the leveraged one would lose $1,500—more than the investor’s actual initial capital.

A great real-life example of what leverage can do comes in the form of leveraged ETFs. Many of them can generate returns amounting to 200-300% in a year but also tend to lose insurmountable amounts of money far more often than generating those stellar returns.

Furthermore, leverage is a complex topic and there are numerous pitfalls. One that is very important for most everyday investors is its availability and affordability. For example, most investors that are neither accredited nor institutional can find it very hard to find a broker willing to lend them money—and can often find that the available contracts are far too expensive to be profitable.

The Role of the Sharpe Ratio 📝

The Sharpe Ratio is often mentioned when people are talking about the effectiveness of a risk parity portfolio. The basic function of this ratio is to differentiate between the really great investments and some sugar-coated bitter herbs. 

This analysis tool simply finds the best low-risk investment and uses it as a benchmark to which it compares any other risk asset-based trade. The results of the Sharpe ratio always go a long way in explaining why risk parity portfolios tend to do a great job in a bear market—and tend to be used to determine just how well a risk parity portfolio is constructed.

Risk Parity vs. Modern Portfolio Theory ⚔

Both the modern portfolio theory and risk parity seek both to generate returns for the investors and to protect them from losses using diversification. As we’ve mentioned before, this is achieved by investing in different types of assets. These assets are often found using negative correlation—the assets used for diversification should behave in opposite ways under the same circumstances.

Basically, it would be pointless to try and diversify by investing in Pepsi and Coke simultaneously. Since both belong to the same industry, it is reasonable to assume that they are both subject to how society is viewing very sugary drinks—and will behave similarly under the same circumstances.

The Basic Strategy ⚙

The first key difference between these two approaches comes from what they value. MPT seeks its investments by looking at return rates. While this is very intuitive—every investor wants to make as much money as possible—it has several major drawbacks. Pretty much all forms of analysis of the market are attempting to predict future performance using historical data.

On the one hand, stock analysis can be accurate and effective provided an investor has enough know-how and is using the right software—but on the other, not all data is created equal. Generally speaking, return rates tend to be far less stable than risk levels and are therefore far harder to predict.

Risk parity’s focus on risk when determining portfolio allocation makes it more of a precision tool as it tends to be working with a lot more reliable data.

Keeping Things Slow and Steady vs. Being Agile and Alert

Another major difference between MPT and risk parity is the tools they use. Modern portfolio theory emphasizes long-term investing and buy-and-hold strategies. The thinking behind this is that the market as a whole is a lot more rational than the investors and traders. 

This approach is generally vindicated whenever one looks at the historic performance of the market. There have been grueling bear markets, true, but the market has grown many fold over the past hundred years. Furthermore, buy-and-hold strategies can be wildly profitable as is showcased in stories like the one about a guy who bought stocks two decades ago, forgot about his purchase plan, and ended up $100,000 richer.

On the flip side, risk parity emphasizes an active approach. It involves a lot of leverage, short selling, and diversifying through alternative investments. It is hard not to see the advantages of this. An agile and active investor can take advantage of opportunities as they arise, and avoid dangers whenever they crop up and make an absolute killing.

The riskiness of being active with trades and investments is largely mitigated due to the lower risk nature of risk parity. However, this also showcases a weakness of risk parity—actively managing and frequently rebalancing a portfolio takes a lot of time, energy, and knowledge, and can incur steep fees.

Investing in Risk Parity 💰

The theoretical framework for risk parity has been in the works since the early 1950s and has seen continuous development over the following 50 years. The initial idea can be traced back to the Nobel prize winner Harry Markowitz and his work on the efficient frontier.

The framework has been further expanded on by other famous names such as James Tobin, Jack Traynor, and William Sharpe. However, it was very difficult to apply the ideas of risk parity to major portfolios of the day—applying adequate leverage being particularly troublesome.

Risk parity saw its major commercial debut when Bridgewater launched an All Weather investment strategy in 1996. While Bridgewater is still famous for its various all-weather funds, it is important to note that major hedge funds are not the only way of achieving risk parity.

Furthermore, all weather is not a synonym for risk parity—all-weather approaches apply various strategies designed to help a portfolio do well in both bear and bull markets.

Over the years, various specialty funds utilizing a risk parity approach have been created—including hedge, exchange-traded, and mutual funds. These tend to be a fairly good way of easily achieving diversification while staying within the desired risk level as even niche funds invest in a wide variety of assets.

A fund called RPAR risk parity ETF went a relatively long way in showcasing that investing in this strategy is far from riskless. While risk parity portfolios proved resilient during the 2008 financial crisis, RPAR ETF shared in the struggles of the broader market since its inception in late 2019. It suffered comparable losses to the wider S&P 500 index both at the beginning of 2022 and kept limping throughout the spring.

Generally speaking, investing in risk parity is not too different from any other market activity. No matter how good the overarching strategy is, the ultimate results will depend on the actual execution. All of this can make forgoing major funds and management firms fairly appealing—and going at it alone can certainly be done.

However, building and managing an efficient risk parity portfolio can be tricky for numerous reasons. It isn’t always easy to calculate properly, markets and assets required for proper diversification can be inaccessible, and leverage can prove expensive.

Calculating Risk Parity 🧮

Since calculating risk parity takes multiple steps—and wrapping your head around some formulas you probably haven’t seen since high school—it is good to know that it isn’t too hard to automate the process. This can be done both through one of the many online calculators and directly through a reliable stock broker.

It is important to find a way to calculate risk parity yourself since various firms tend to have different versions of risk parity. Ultimately, these differences can’t be too large—the theoretical backdrop for this investment approach is mostly universal—but can be significant enough to create unexpected results.

Generally, risk parity variations tend to stem from how exactly volatility is weighted, which benchmark is chosen, and what kind of leverage is applied. Another important factor that can separate successful portfolios from the losers are the operating costs.

These include the fund’s management fee—the 2 and 20 structure of many hedge funds is often particularly dreaded—and the cost of borrowing. The price of leverage can sometimes be so high that it can negate all the benefits of amplifying the investment.

Management fees tend to increase in importance when more volatile assets are added as they can cause a portfolio to be rebalanced more often in order to maintain risk parity.

Related Approaches 🔗

Any type of portfolio building that seeks to lower overall volatility can be seen as an approach related to risk parity. In broad strokes, this means that a strategy of asset allocation offering a lower risk than a traditional 60/40 portfolio can be leveraged in a similar way to a risk parity build.

A key metric to look out for is the Sharpe ratio. As a rule of thumb, a risk-parity-related portfolio with a worse Sharpe ratio than a traditional 60/40 spread isn’t successfully built and should not be leveraged. If there are indications of heightened risk, levering assets can often lead to amplified losses rather than improved gains.

A very simple type of portfolio that is often considered related to risk parity is the so-called equally weighted portfolio. This strategy is notable since it gives equal weight to all assets included in the overall investment—it disregards volume, market cap, value, and class. Equally weighted portfolios are generally well-diversified.

However, the overall risk and diversification of such portfolios can vary widely on a case-by-case basis. If a portfolio is filled to the brim with only volatile penny stocks, it will be a high-risk investment no matter the allocation strategy.

Furthermore, if an equal-weight portfolio contains the stocks of only three different companies it can’t be considered diversified. These two considerations are relevant for pretty much any strategy of portfolio building.

Alternative Investments 🗃

Alternative investments can be a bit of a touchy subject. On the one hand, they tend to have very low volatility and practically non-existent correlations with other asset types—not to mention that they encompass numerous completely unrelated assets. On the other, fund managers are usually reluctant to substantially invest in alternative assets due to numerous reasons.

To understand the place of alternative investments in a risk parity portfolio, we must first understand what they are. In a nutshell, they represent any asset that isn’t normally traded on the market. For example, special wines and whiskeys can be considered good alternative investments. The same goes for rare vintage cars, exquisite rugs, and artworks—Van Gogh’s Starry Night is an excellent alternative investment if you can get your hands on it.

More recently, cryptocurrencies have become an alternative investment of choice for many. However, this type of asset recently showcased one of the reasons managers are reluctant to allocate significant portions of a portfolio to non-standard assets. While alternative assets are often considered less volatile, they can certainly appreciate and depreciate in value quite significantly.

Furthermore, alternative investments can be both somewhat difficult to come by, and rather illiquid. A one-of-a-kind 17th-century bottle of wine won’t help you in a pinch if you can’t set up a proper auction. Additionally, uncommon markets can present uncommon challenges—some of which can force an investor to either become an expert in niche commodities or risk losing big.

Cryptocurrencies can be particularly vulnerable to malicious parties due to some peculiarities in their design. A crypto called Beanstalk made headlines when a foundational principle known as code is law was used to completely wipe its value.

Obviously, none of this means that alternative investments are inherently bad—the situation is quite the opposite. However, it does highlight just how much reckless diversification can hurt an investor.

Building a Risk Parity Portfolio 🏗

Building a risk parity portfolio can be tricky on multiple levels. The first, and most obvious one is that an investor has to figure out which assets they actually want to acquire. This initial stage has multiple levels. It is necessary to decide whether the portfolio should contain only stocks and bonds, or if it should also contain commodities, derivatives, options, etc.

Furthermore, a great deal of care has to be placed on which stocks and bonds should be included—there are almost an infinite number of combinations. A properly executed fundamental analysis can be an important first step in portfolio building.

When an investor lays down these foundations, they have to select the desired risk level, reconsider their choices to best conform to the plan, and keep a careful eye on changing circumstances to always stay on top.

So, let’s take a deeper dive into the key steps of building a risk parity portfolio.

Traditional Asset Allocation 🧐

While it is certainly possible to arbitrarily set the desired risk level, it isn’t optimal. Going in blind like this can lead to either unnecessarily high volatility or one that is unreasonably low. Creating a traditional asset allocation before calculating risk parity can create a reliable benchmark.

Traditional asset allocations include the 60/40 approach—the portfolio is made up of 60% stocks and 40% bonds—and the age-based approach where older investors hold a large proportion of bonds or even an equal weight portfolio.

While the 60/40 portfolio is often seen as severely flawed, it continues to outlast its detractors. Therefore, it is often considered a good benchmark. This means that the volatility of a risk parity allocated portfolio has to be lower than that of a traditional one.

Security Market Line 🛡

A security market line is a helpful tool both when creating the initial risk benchmark, and when adapting it to risk parity. In a nutshell, SML is a graphical representation of risk and returns—and of their relations. 

The security market line is determined by the market’s overall beta and is always an upward-sloping dash on the chart. It is in fact a standardized representation of the fact that higher risk usually brings higher potential returns.

If a particular stock finds itself above the SML on a chart it represents a better investment opportunity as it is undervalued compared to its amount of risk. Conversely, stocks beneath the line have a level of volatility that outweighs the reward.

Still, it is important to note that a stock that is above the SML but close to its peak has dubious value to an investor. The fact that its potential returns are more than 1000% is hardly worth anything if it has a 99% chance of actually losing money.

Similarly, a bond that is almost guaranteed not to depreciate in value isn’t a valuable investment if it has no growth potential. Once inflation outpaces the return rate, an investor is bound to lose money—especially when the inflation rate is close to 9% for the first time in four decades.

Leverage 💼

Leverage is an important tool for risk parity—but it truly highlights that great responsibility comes with great power. Leverage represents borrowing money—often directly from the broker—to amplify the size of an investment. It follows the basic logic that owning 1000 shares that increase in value by $10 each is much better than owning 100.

However, it is equally easy to see that owning 100 shares that lose $10 in value each is far worse than having just 10. This problem can be severely compounded by the use of leverage. For example, consider an investor with $1000. They may choose to buy 10 shares of company X for $100 each.

If the shares go up in value by 10%, the investor makes $100. If they fall by 10%, the investor loses $100 out of the $1000 investment. However, by leveraging the trade, the investor can make $1000 from the initial $1000 investment under the same circumstances. Similarly, if things go wrong, the investor can lose their entire investment just from value depreciation.

Furthermore, their losses will probably not be limited to just $1000. Lending often comes at a premium, and even a fee of 1, 2, or 3% can cause the investor to lose more than 100% of their initial capital.

Reckless use of leverage can cause profound problems, cause bizarre levels of volatility, and generally damage lives and livelihoods. Furthermore, overleveraging trades can substantially cripple an asset’s ability to regain lost value—in fact, some crypto markets found themselves under such threat during the crypto tumble of 2022.

However, risk parity is deeply reliant on leverage. In fact, it is mostly designed with it in mind. The basic idea of this allocation strategy is to make a portfolio’s volatility so low that it is less risky leveraged, than a traditional allocation is without any leverage.

An investor can ensure that their portfolio is safe from major losses by carefully choosing which trades to leverage, and by making sure that the Sharpe ratio after applying risk parity is truly significantly lower than before.

Furthermore, by hedging bets against one another, an investor can ensure they won’t be losing money even when making a bad trade. A cornerstone of hedging—and, more broadly, of diversification—is properly understanding correlations between assets.

Correlation 🖇

Correlation follows how the stocks of company A perform compared to the stocks of company B under similar circumstances. As we’ve touched upon briefly, Coke and Pepsi tend to generate returns and losses at the same time under the same circumstances due to belonging to the same industry. This means that they are correlated and can’t be used together to increase diversification.

This doesn’t mean that it is always so easy to figure out which stocks are closely correlated. For example, airlines and car manufacturers tend to do poorly when oil prices go up. 

Considering just how high oil prices were getting in the summer of 2022, an investor might assume that automobile companies and airlines would be doing nothing but losing money—and this is true to an extent, but far from universal.

Delta Airlines has been doing very poorly since the beginning of 2022, and Dodge dramatically mimicked this trend. However, the automobile-making Tesla and Toyota have been doing a bit better. Tesla started recovering after huge losses during springtime, while the Japanese company has been going pretty strong overall. So, what’s the difference?

The elephant in this room is that both Toyota and Tesla are major electric car producers, while Dodge is still completely fossil-fuel-based. Similarly, there are no electric jet liners available for Delta to operate.

This simple fact makes Delta and Dodge on the one side, and Tesla and Toyota on the other somewhat negatively correlated. Thus, buying both Delta and Toyota stocks can further the diversification of a portfolio.

Obviously, starker negative correlations can be found all around the market. A potentially interesting place to look for them is among the so-called cyclical stocks. Briefly, cyclical stocks belong to industries that tend to do really well for some time before the circumstances change and they suffer losses. After some time, the environment changes again and they generate great returns once again.

It is possible to find very strong negative correlations among these stocks, however, it is important to remember that most market cycles are somewhat long-lasting. This makes most cyclical stocks better suited for hedging in long-term investment strategies.

Portfolio Management 👨‍💻

While volatility usually adheres to historic patterns more closely than expected returns, risk levels are hardly set in stone. In fact, these ups and downs are even more pronounced when the market is struggling—that is to say precisely when risk parity portfolios are designed to shine.

Since risk parity utilizes various shorter-term tactics like short selling and leverage, any change in the volatility and value of assets is an immediate call to action. Additionally, since risk parity always seeks to maintain equal levels of risk across all asset classes, changes in volatility make rebalancing the portfolio mandatory.

These characteristics carry both benefits and drawbacks. Constantly rebalancing your portfolio—and risk truly equalized—can ensure you aren’t fiddling while Rome is burning, and can help you take advantage of opportunities as they arise.

This has some key advantages over more long-term diversification strategies as it can help you avoid losses rather than absorb them. Staying vigilant and agile is especially important if you don’t have time on your side—if you can’t afford to wait a long time for the market to recover before you cash in your investments. On the other hand, it is possible to have a thriving portfolio even if you don’t alter it at all from your initial allocation as was fascinatingly demonstrated in the allegory of the hawk and serpent.

One of the most common drawbacks of fiddling with a portfolio too much comes in the form of severely increased fees. Usually, the more hands-on the approach of a manager is, the higher the operational costs get. This makes picking the right broker for a risk parity portfolio almost compulsory.

Pros and Cons ⚖️

Risk parity made its first true appearance in 1996 and made a name for itself during the 2008 crisis. To this day, it is considered one of the asset allocation approaches that have definitely proved their worth. However, its performance during covid-19 was lackluster compared to expectations.

Due to the range of tactics risk parity employs, it is hard to accurately determine what its performance will really be. Furthermore, it can lead to diminished returns due to higher management and leverage costs. At its worst, it can magnify an investor’s losses manyfold if leverage is recklessly applied.

At its best, risk parity provides a reliable way for an investor to protect themself from market downturns and excessive risk while greatly improving the returns of more traditional asset allocations. Risk parity also nearly guarantees an excellently diversified portfolio while helping you be mindful of the market volatility—which can often be dangerously overlooked in the face of stellar potential returns.

Conclusion 🏁

Risk parity exists in a very weird place. It owes its theoretical basics to some of the biggest Nobel-prize-winning names in the history of economics and checks many of the boxes important for investing—like excellent diversification and risk-mindfulness. Risk parity portfolios also performed comparatively very well during the biggest market crash of the 21st century.

On the flip side, relatively few experts are entirely willing to unconditionally endorse risk parity. This isn’t all that surprising since this allocation strategy is built upon some concepts that don’t sit entirely well with everyday investors like leverage and short selling. 

Furthermore, risk parity isn’t fully tested. While designed to truly shine during a bear market, nearly half of its existence is encompassed by the longest bear market in history—which lasted for over a decade despite some near-death experiences.

Ultimately, risk parity isn’t that different from many other modern-portfolio-theory-based allocation strategies. It is built on rather solid foundations and employs various fairly effective tools, but will always depend on how well a particular portfolio is built. 

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