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Victor Haghani and James White

Some Clarity on Risk Parity

Risk parity and traditional portfolios are usually presented as being philosophically miles apart, but they are actually much closer.
Don't fear risk parity.

Don't fear risk parity.

Photographer: Bryan R. Smith

Google “risk parity” and you’ll see a grab bag of conflicting results: articles and posts trying to explain what it means, why it reduces stock-market volatility, why it increases stock-market volatility, why it’s less risky than a traditional portfolio, or why it’s more risky, among other things.  We’ll try to cut through this confusion to show that risk parity and traditional portfolios are closely related in philosophy. 

Risk parity is all about how an investor allocates risk, not capital, typically with the use of leverage and with the idea that an equal risk allocation to various asset classes increases the benefits of diversification. Risk parity and traditional portfolios are usually presented as being philosophically miles apart, and hard to compare or analyze side by side except by looking at the historical record, such as in the chart below. The problem, though, is that financial market history is limited in that it reflects only a very specific set of historical conditions and, as we know, past performance isn’t indicative of future results. 

What’s an investor to think? Both types of portfolios come out of the same theory of portfolio construction, but with different sets of basic starting assumptions. The theoretical toolkit we’re talking about here is the “Optimal Expected Utility” framework applied to financial markets by Paul Samuelson and his protégé Robert Merton starting in the 1960s.  Their work helped them both garner a Nobel Prize, and produced a set of practical tools for determining how much of one’s wealth should be allocated to different investments with the understanding that the future is uncertain. The tools are primarily based on an investment’s expected excess return, volatility, and the investor’s personal level of risk-aversion.