An Introduction to Risk Parity

In the aftermath of the financial crisis, investors and asset allocators have started the usual ritual of rethinking the way they approached asset allocation and risk management. Academic/Practitioner journals are full of articles that are supposed to show investors what went wrong and how they can adjust their models and theories in order to protect themselves against substantial losses next time equity and credit markets experience significant losses. Most of these recommendations should be viewed with a great deal of skepticism as they are bound to incorporate a healthy dose of data snooping and over fitting biases. For example, both Barclay Capital Global Bond Index and MSCI World Equity Index have earned about 7% annual nominal return since 1990, with volatility of the bond index being about 1/3 of the volatility of the equity index. Clearly, going forward it is all but impossible for the bond index to repeat the performance of the last 20 years. Therefore, any model that would recommend a significant allocation to fixed instruments should be carefully analyzed and its assumptions should be questioned. The so-called risk parity approach to asset allocation has enjoyed a revival during the last few years because such a portfolio would have outperformed the “normal” portfolios with their typical significant allocations to equities. In this note, we discuss the risk parity approach to asset allocation and examine its underlying assumptions. The central idea of the risk parity approach is that in a well-diversified portfolio all asset classes should have the same marginal contribution to the total risk of the portfolio. For example, as shown below, in a typical 60/40 portfolio, equity risk accounts for almost 90% of the total risk of the portfolio, which is significantly higher than its weight, 60%. Under the risk parity approach, there is generally a significant allocation to low risk asset classes and allocations to equities and other risky assets are typically below what we normally observe for most diversified institutional quality portfolios. Therefore, we want to know if this approach is based on sound economic and financial reasoning or is it just another attempt to extrapolate the results of the last ten years into the future.