Investors need a diversified portfolio to mitigate any risks that come with their investments. During this process, they can use several techniques or approaches. Traditionally, most investors make decisions based on their objectives. However, investors can also build a portfolio based on their risk appetite. One approach they can use during this process is risk parity.
What is Risk Parity?
Risk parity is a strategy that investors use when constructing their portfolios. Using this approach, investors first evaluate their risks by considering several factors. For that, investors need to use the risk contribution for each asset class in relation to the overall portfolio. After that, they can establish how to allocate funds across the several asset classes in their investment portfolio.
The risk parity approach to building a portfolio relates to the Modern Portfolio Theory (MPT). MPT seeks to explain a method that investors can use to develop a diversified portfolio. This portfolio focuses on maximizing the expected returns that investors can get for a specific market risk level. Risk parity uses a similar approach by diversifying a portfolio into several asset classes based on the risks and returns of the whole portfolio.
How does Risk Parity work?
Risk parity is a portfolio management strategy that investors can use for their portfolios. It depends on leverage to help investors diversify the risks associated with their investment portfolios. It also focuses on maintaining returns at an expected level in the long run. By allowing investors to incorporate leverage, risk parity helps investors reduce their risks to achieve equity-like returns.
Risk parity focuses on leveraging a portfolio to allocate more funds towards lower-risk assets. Using this approach, we seek to deliver higher returns than investing in higher-risk assets. It also goes against other traditional asset allocation strategies. Unlike those strategies, risk parity focuses on more investments in bonds compared to stocks or equities.
By doing so, risk parity ensures that investors receive similar returns from both their equity and debt investments. However, investors usually consider their risks and return levels before making these decisions. It also goes against other asset allocation strategies that use a fixed or predetermined mix for both asset classes.
What are the advantages and disadvantages of Risk Parity?
Risk parity can be a significantly beneficial strategy for investors as it helps them minimize their returns while minimizing risks. Unlike some other traditional asset allocation strategies, risk parity considers investors’ risk and return levels. By doing so, investors can identify their specific risk level and divide it across their overall portfolio to achieve better diversification.
There are several other tools that can also help investors with their objectives. One such tool is the security market line that is a graphical representation of risks and returns. By allowing investors to use leverage, risk parity can help equalize the volatility and risks that investors undertake in their portfolios.
However, there are some limitations that this strategy includes. Some experts believe that using volatility as a basis for asset allocation does not represent an appropriate risk measure. It may also leverage low-risk assets to counterbalance the risks that investors undertake with other asset classes. In some instances, it may cause a portfolio imbalance.
There are several approaches to constructing and managing portfolios. Risk parity is a strategy that allows investors to evaluate their risks when building their investment portfolio. It aims to achieve lower risks at higher returns. There are several advantages of using this strategy. However, it may also come with some drawbacks, as mentioned above.