Module II·Article II·~2 min read
Risk Parity Concept
Asset Allocation and Multi-Asset Strategies
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Risk Parity: a Revolution in Allocation
Risk Parity is an approach to portfolio construction where each asset class contributes an equal share to the overall portfolio risk, rather than occupying an equal share of the capital. Popularized by Ray Dalio (Bridgewater) in the 1990s.
The Problem of the Traditional Approach
In a 60/40 portfolio, capital allocation:
- Stocks: 60%
- Bonds: 40%
But risk allocation is completely different:
- Stocks: ~90% of total risk ($\sigma_\text{stocks} = 16%$, $\sigma_\text{bonds} = 5%$)
- Bonds: ~10% of total risk
Problem: When stocks fall, almost the entire portfolio falls. Bonds do not provide enough protection.
The Idea of Risk Parity
Instead of equal dollars—equal units of risk:
| Parameter | 60/40 | Risk Parity |
|---|---|---|
| Stock weight | 60% | ~25% |
| Bond weight | 40% | ~55% |
| Commodities weight | 0% | ~20% |
| Stock risk share | ~90% | ~33% |
| Bond risk share | ~10% | ~33% |
| Commodities risk share | — | ~33% |
Risk Parity Mathematics
For a portfolio of $n$ assets, the contribution of asset $i$ to total risk:
$ RC_i = w_i \times \left( \frac{\partial \sigma_p}{\partial w_i} \right) $
Risk Parity requires:
$ RC_1 = RC_2 = \ldots = RC_n $
Problem and Solution: Leverage
With equal risk allocation, the portfolio will have too many bonds → low return.
Solution: Use leverage to increase exposure to low-volatility assets.
| Parameter | Risk Parity w/o leverage | Risk Parity with leverage |
|---|---|---|
| Total capital | 100% | 100% |
| Gross exposure | 100% | 150–200% |
| Expected return | 4–5% | 7–9% |
| Volatility | 6% | 10% |
All Weather Portfolio (Bridgewater)
The most famous Risk Parity implementation by Ray Dalio:
| Economic regime | Assets | Approximate weight |
|---|---|---|
| Growth above expectations | Stocks, Commodities, EM | 25% |
| Growth below expectations | Government Bonds, TIPS | 25% |
| Inflation above expectations | TIPS, Commodities, Gold | 25% |
| Inflation below expectations | Stocks, Government Bonds | 25% |
Advantages of Risk Parity
- True diversification — no asset class dominates
- Robust to regimes — works in different economic environments
- Not dependent on return forecasts — only on risk estimation
- Historically high Sharpe ratio — 0.6–0.8
Disadvantages and Risks
- Requires leverage — increases operational risks
- Sensitivity to rates — high bond weight = high duration risk
- 2022 failure — all components declined simultaneously
- Implementation complexity — requires dynamic management
- Cost of leverage — expensive at high rates
When Does Risk Parity Work Well?
- Low and stable interest rates
- Negative stock-bond correlation
- Low funding cost
When Is Risk Parity Vulnerable?
- Inflationary shocks (2022)
- Sharp rate hikes
- Liquidity crisis (leverage amplifies losses)
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