The risk parity method of investment portfolio construction aims to allocate capital in the investment portfolio on a risk-weighted basis. Asset allocation is the process by which investors allocate capital in their investment portfolio to different types of assets. The traditional portfolio allocation is 60% stocks and 40% bonds. However, this distribution is not effective during periods of stock market declines and economic instability. The risk parity approach attempts to avoid the risks and biases of traditional investment portfolio diversification. Taking into account the volatility of the assets contained in the investment portfolio, it allows the construction of the best investment portfolio.
Traditional asset allocation
The traditional view is to allocate 60% of the portfolio to stocks and 40% to bonds and other fixed income instruments. Another common adage is to subtract the investor’s age from 100 to determine the percentage that should be allocated to the bond. Although this will certainly create a more diversified portfolio than just owning stocks or only bonds, it cannot withstand volatility and economic recession.
In this traditional portfolio allocation, stocks constitute 90% of portfolio risk. Historically, the volatility of stocks is three times that of fixed-income securities. Higher stock volatility outweighed the diversification of bonds. Traditional portfolio allocation performed poorly during the 2008 financial crisis, as the stock market fell sharply during the period of increased volatility. Risk parity avoids this concentration of risk in stocks.
Securities Market Line
The focus of risk parity allocation theory is to help investors build a portfolio that is sufficiently diversified but still able to obtain significant returns. Risk parity uses the concept of stock market lines as part of its approach.
The securities market line is a graphical representation of the relationship between asset risk and return. It is used in the Capital Asset Pricing Method (CAPM). The slope of the line is determined by the beta value of the market. The line slopes upward. The greater the likelihood of an asset’s return, the higher the risk associated with that asset.
There is a built-in assumption that the slope of the securities market line is constant. The constant slope may actually be inaccurate. For the traditional 60/40 allocation, investors must take greater risks in order to obtain acceptable returns. As risky stocks are added to the portfolio, diversification gains are limited. Risk parity solves this problem by using leverage to balance the volatility and risk volume of different assets in the portfolio.
Use of leverage
Risk parity uses leverage to reduce and diversify equity risk in the investment portfolio, while still aiming for long-term performance. The careful use of leverage in liquid assets can individually reduce the volatility of stocks. Risk parity seeks returns from similar stocks for lower-risk portfolios.
For example, a portfolio with 100% allocated to stocks has a risk of 15%. Suppose a portfolio uses a moderate leverage of approximately 2.1 times the amount of capital in the portfolio, of which 35% is allocated to stocks and 65% is allocated to bonds. The expected return of the investment portfolio is the same as that of the unlevered investment portfolio, but the annualized risk is only 12.7%. This reduces the risk by 15%.
The use of leverage can be further applied to investment portfolios that include other assets. The point is that there is no perfect correlation between the assets in the portfolio. Leverage is used to evenly distribute risk among all asset classes included in the portfolio. The use of leverage essentially increases the diversification of the investment portfolio. This reduces the overall portfolio risk while still allowing substantial returns.
The role of correlation
Correlation is an important concept for constructing risk parity portfolios. Correlation is a statistical indicator that measures how the prices of two assets are related to each other. The measure of the correlation coefficient is a measure between -1 and +1. The correlation of -1 represents a perfect reverse relationship between the prices of two assets. Therefore, when one asset rises, the other asset will keep falling. The correlation of +1 indicates that there is a perfect linear relationship between the prices of the two assets. Both assets will move in the same direction with the same magnitude. Therefore, when one asset increases by 5%, the other asset will increase by the same amount. A correlation of 0 means that there is no statistical relationship between asset prices.
It is often difficult to find perfect positive and negative correlations in finance. Nevertheless, including assets that are negatively related to each other can increase the diversity of the portfolio. Correlation calculations are based on historical data; there is no guarantee that these correlations will continue to exist in the future. This is one of the main criticisms of modern portfolio theory (MPT) and risk parity.
Rebalance demand and management
The use of leverage in the risk parity approach requires periodic rebalancing of assets. It may be necessary to balance leveraged investments to maintain volatility exposure at the level of each asset class. Risk parity strategies may use derivatives, so these positions need to be actively managed.
Unlike stocks, asset classes such as commodities and other derivatives require close attention. There may be margin calls that require cash to maintain positions. Investors may also need to roll over their positions to different months instead of holding the contract until maturity. This requires active management of these positions and the cash in the portfolio in response to any margin call. There is also a higher degree of risk when using leverage, including the risk of counterparty default.
Similarities with modern portfolio theory
MPT and risk parity methods have a lot in common. According to MPT, if asset classes do not have perfect correlation, the total risk of any portfolio is less than the amount of risk for each asset class. MPT also seeks to construct an investment portfolio along the effective boundary by including diversified assets based on correlation. Both MPT and risk parity methods focus on the historical correlation between different asset classes in the construction of a portfolio. Increased diversification can reduce overall portfolio risk.