The risk parity portfolio building technique tries to allocate capital in a portfolio on a risk-weighted basis. The process by which an investor distributes the money in a portfolio across various kinds of assets is known as asset allocation. The standard asset allocation is 60% shares and 40% bonds. This allocation, however, does not function well amid stock market downturns and economic insecurity.
The risk parity strategy seeks to avoid the risks and skews associated with typical portfolio diversification. It enables the creation of an optimum portfolio while taking into account the volatility of the assets in the portfolio.
- A risk-parity allocation technique is used in portfolios that assess the relative riskiness of assets.
- This technique, which adheres to the ideas of modern portfolio theory (MPT), use the efficient frontier and security market line (SML) to determine optimum asset allocation.
- With risk-parity, you may also borrow or sell short in order to obtain the optimum risk-reward tradeoff.
Traditional Asset Allocation
The conventional wisdom is that 60% of a portfolio should be allocated to stocks and 40% to bonds and other fixed-income products. Another typical maxim is to divide an investor’s age by 100 to estimate the proportion that should be devoted to equities (thus, a younger person would have more stocks relative to bonds).While this creates a more diversified portfolio than merely equities or bonds, it falls short of being able to weather volatility and economic downturns.
Equities account for 90% of portfolio risk in this standard portfolio allocation. Equities have historically had three times the volatility of fixed income products. The increased equities volatility outweighs the bond’s diversification advantages. During the 2008 financial crisis, conventional portfolio allocation did not fair well, as stocks declined sharply due to the period’s increased volatility. This concentration of risk in shares is avoided through risk parity.
Security Market Line
The risk parity allocation theory is concerned with assisting investors in creating portfolios that are properly diversified but yet capable of producing big returns. Risk parity incorporates the notion of the security market line (SML) into its strategy, which is based on modern portfolio theory (MPT) and the capital asset pricing model (CAPM).
A security market line is a graphical depiction of the connection between an asset’s risk and return. The slope of the line is dictated by the market’s beta. The line is slanted upward. The larger an asset’s potential return, the greater the risk connected with that asset.
The assumption is that the slope of the securities market line remains constant. The continuous slope may not be correct. To get acceptable returns with the standard 60/40 allocation, investors must assume more risks. As riskier securities are added to the portfolio, the diversification advantages diminish. Risk parity addresses this problem by employing leverage to equalize the level of volatility and risk across the portfolio’s assets.
Use of Leverage
Leverage is used in risk parity to decrease and diversify equity risk in a portfolio while still aiming for long-term performance. Leverage in liquid assets used prudently may lessen the volatility of stocks alone. Risk parity seeks equity-like returns for low-risk investments.
A portfolio with a 100% exposure to stocks, for example, has a risk of 15%. Assume a portfolio with a modest leverage of about 2.1 times the amount of capital, with 35% allocated to stocks and 65% allocated to bonds. The predicted return is the same as the unleveraged portfolio, but the annualized risk is just 12.7%. This represents a 15% decrease in risk.
Leverage may also be used to portfolios that include other assets. The crucial point is that the assets in the portfolio are not perfectly correlated. Leverage is utilized to transfer risk evenly across all asset classes in the portfolio. Using leverage effectively boosts portfolio diversity. This lowers total portfolio risk while yet providing for significant profits.
Role of Correlation
Correlation is a key topic to understand when developing a risk-parity strategy. Correlation is a statistical measure of the relationship between two asset prices. A correlation coefficient’s measure is a number between -1 and +1.
A correlation of -1 indicates that two asset prices have a complete negative connection. As a result, if one asset rises, the other asset falls. A correlation of +1 shows that the two asset prices have a perfect linear connection. Both assets will move in the same direction and by the same amount. As a result, if one asset rises by 5%, the other will rise by the same amount. A correlation of zero suggests that no statistical link exists between asset prices.
Perfectly positive and negative correlations are uncommon in finance. Even yet, having assets with negative correlations with one another promotes portfolio variety. Correlation estimates are based on historical data; these relationships are not guaranteed to persist in the future. This is a major critique leveled against both current portfolio theory and risk parity.
Rebalancing Requirement and Management
The use of leverage in a risk parity strategy necessitates frequent asset rebalancing. To maintain the volatility exposure for each asset class, the leveraged investments may need to be evened out. Because risk parity schemes may include derivatives, these positions need active management.
Asset classes such as commodities and other derivatives demand more care than equities stocks. Margin calls may occur, requiring cash to preserve a position. In addition, rather than holding contracts until expiry, investors may need to roll holdings to a new month. Active management of such holdings, as well as funds in the portfolio to satisfy any margin calls, are required. When utilizing leverage, there is also a heightened level of risk, including the possibility of counterparty default.
Similarities With Modern Portfolio Theory
MPT and the risk parity method have many similarities. According to MPT, if the asset classes do not have a perfect correlation, the overall risk of any portfolio is less than the amount of risk for each asset class. Similarly, MPT aims to build a portfolio along the efficient frontier by including varied assets based on correlations.
In portfolio creation, both MPT and the risk parity method consider the historical correlation between various asset classes. Diversification may help to minimize overall portfolio risk.
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