When putting together an investment portfolio, you need to determine a strategy in terms of investment allocation and management.
There are many different approaches used, and one of the most popular is a risk parity portfolio.
If you’ve never heard of this approach before or you’re unsure about how to put it into practice, fear not, as we’ll take you through risk parity portfolios in full in this post so you can get a better understanding and determine whether or not this is right for you.
What is a risk parity portfolio?
A risk parity portfolio is a portfolio allocation strategy that utilizes risk to figure out allocations across a number of components of an investment portfolio.
Asset allocation involves dividing up the capital in your portfolio among various asset types. In conventional portfolios, investors will allocate 40% to bonds and 60% to equities. Nevertheless, this sort of allocation doesn’t perform well during drawdowns in the stock market and periods of economic instability.
The risk parity approach provides an alternative solution. It aims to avoid the skews and risks of conventional portfolio diversification. It enables you to construct an optimized portfolio, which factors in the volatility of the assets in your portfolio.
How conventional asset allocation works
To truly understand risk parity portfolios, we first need to understand how conventional asset allocation works.
The traditional model involves allocating 40% to bonds and other fixed-income instruments, with the majority of 60% being allocated to equities.
A further common maxim is to minus the investor’s age from 100 to figure out the percentage you should allocate to stocks. With this approach, a younger person would have a greater number of stocks in relation to bonds.
While this definitely results in a more diversified portfolio, as opposed to having only bonds or only stocks, it’s not an approach that can effectively ride economic downturns and volatility in the market.
When you go down the conventional route, 90% of the portfolio risk is based on equities. Historically speaking, equities have had three times the level of volatility when compared with fixed-income securities.
The bonds’ diversification benefits are overtaken by the higher equity volatility.
When we look back, we can see that the conventional approach to portfolio allocation did not perform well during the financial crisis in 2008. When this happened, volatility was high, and equities dropped dramatically.
Therefore, it’s not hard to understand why investors are looking toward alternative approaches so that the concentration of risk in equities is avoided. This is where risk parity comes into play and really shows its worth.
What are the main features of a risk parity portfolio?
Now that you have a better understanding of the key differences between risk parity portfolios and traditional investment allocation, let’s delve a little bit deeper into the main features and characteristics of a risk parity portfolio.
There is only one place to begin when discussing the features of risk parity portfolios, and this is with correlation. This is one of the most critical concepts in risk parity portfolio construction.
For those who are unaware, correlation is a statistical measure of how the prices of two assets move in regard to one another. The measure of the correlation coefficient is somewhere between +1 and -1.
Historical data is used to determine correlations. Therefore, it’s vital to recognize that there is no guarantee that these trends will continue into the future, as we’re only focusing on what has already been. This is one of the main criticisms people have of risk parity portfolios.
So, what do the different measures of correlation actually mean?
A correlation of +1 indicates that there is a perfectly linear relationship between both assets and their prices. Both of the assets will move in the same direction and with the exact same magnitude. So, if one of the assets increases by 10%, the other asset is also going to increase by 10%.
On the flip side, if the correlation stands at -1, this means that there is a perfectly inverse relationship between the prices of both assets. So, if one asset goes up by 10%, the other asset is actually going to go down by 10%.
If the correlation coefficient is 0, this means the asset prices don’t have any sort of statistical relationship to draw upon.
As you may expect, it’s incredibly difficult to find perfectly negative and positive correlations in the world of finance.
Nevertheless, if you include assets that have negative correlations in your portfolio, it will greatly boost diversification.
- The use of leverage
Risk parity utilizes leverage to lower and diversify a portfolio’s equity risk while still driving performance in the long run.
The prudent utilization of leverage in liquid assets can lower how volatile equities are.
The aim of a risk parity portfolio is to seek equity-like returns for portfolios while lowering risk at the same time.
A working example
For instance, if your portfolio has a 100% allocation to equities, the risk degree is approximately 15%. If we assume moderate leverage for the portfolio of roughly 2.1 times the amount of capital in a portfolio, with 65% allocated to bonds and 35% allocated to equities.
This sort of portfolio is going to generate the same expected return as a portfolio that is unleveraged, yet there will be an annualized risk of just 12.7%. This means that the amount of risk is reduced by a massive 15%.
You can further apply the use of leverage to portfolios when they contain other assets as well.
The main point here is that the assets in your portfolio don’t boast perfect correlation.
Leverage is utilized to distribute risk equally among every asset class incorporated within your portfolio.
By making the most of leverage in this way, you’re going to considerably boost how diverse your portfolio is. This lowers the overall risk while still giving you the platform to make a significant return on your investment.
Next, you regularly need to rebalance your assets if you follow the risk parity approach.
You may need to even out your leverage assets so that you can keep the volatility exposure level for every asset class.
Derivatives can also be used as part of risk parity portfolios, and these positions need to be managed on an active basis.
Commodities and other derivatives require much closer attention when compared with the likes of equity stocks, so you do need to keep this in mind.
You may also need cash to maintain positions for margin calls.
Therefore, you need to make sure you’re able to constantly manage your portfolio and make adjustments as and when is needed.
- Security market line
The risk parity approach concentrates on assisting investors in creating portfolios that are diversified to a sufficient level while still being able to generate high returns.
Security market line (SML) is a concept that is used as part of the risk parity approach. This combines the capital asset pricing model (CAPM) and the modern portfolio theory (MPT).
The security market line is a geographical representation of an asset’s relationship between risk and return.
The beta of the market determines the slope of the line. So, if the line is sloping upward, this means there is a higher chance for the investor to get a return on the asset, but also there is a greater level of risk at the same time.
There is the assumption that the securities market line slope is constant. However, the constant slope may not be truly accurate.
For the conventional 60/40 split in assets, investors are going to need to take much higher risks to get an acceptable return on their investment.
The diversification advantages are restricted, as riskier equities are included in the portfolio.
Risk parity resolves this problem by utilizing leverage to equalize the amount of risk and volatility across the various assets in the portfolio.
Mastering your risk parity portfolio
As you can see, there is a lot that needs to be considered when putting together the perfect risk parity portfolio for your investments. We hope that the information we have provided you with above has helped you to understand how these portfolios work and what you can do to master this form of investment.