Risk Parity

AAA

DEFINITION of 'Risk Parity'

A portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio. The risk parity approach to asset allocation allows investors to target specific levels of risk and to divide that risk equally across the entire investment portfolio in order to achieve optimal portfolio diversification for each individual investor. Risk parity strategies are in contrast to traditional allocation methods that are based on holding a certain percentage of investment classes, such as 60% stocks and 40% bonds, within one's investment portfolio.

INVESTOPEDIA EXPLAINS 'Risk Parity'

The risk parity approach to portfolio asset allocation focuses on the amount of risk in each component rather than the specific dollar amounts invested in each component. In other words, risk parity focuses not on the allocation of capital (like traditional allocation models), but on the allocation of risk. Risk parity considers four different components: equities, credit, interest rates and commodities, and attempts to spread risk evenly across the asset classes. The goal of risk parity investing is to earn the same level of return with less volatility and risk, or to realize better returns with an equal amount of risk and volatility (versus traditional asset allocation strategies).

A traditional 60/40 portfolio can attribute 80 to 90% of its risk allocation to equities. As a result, the portfolio's returns will be dependent upon the returns of the equity markets. Proponents of the risk parity strategy state that while the 60/40 approach performs well during bull markets and periods of economic growth, it tends to fail during bear markets and economic slumps. The risk parity approach attempts to balance the portfolio to perform well under a variety of economic and market conditions.

Several risk parity-specific products, including mutual funds, are available, and investors can also build their own risk parity portfolios through careful research or by working with a qualified financial professional. The first risk parity fund, the All Weather hedge fund, was introduced by Bridgewater Associates in 1996.

RELATED TERMS
  1. Strategic Asset Allocation

    A portfolio strategy that involves setting target allocations ...
  2. Diversification

    A risk management technique that mixes a wide variety of investments ...
  3. Portfolio

    A grouping of financial assets such as stocks, bonds and cash ...
  4. Asset Allocation

    An investment strategy that aims to balance risk and reward by ...
  5. Risk

    The chance that an investment's actual return will be different ...
  6. Cape Cod Method

    A method used to calculate loss reserves that uses weights proportional ...
RELATED FAQS
  1. What is a "linear" exposure in Value at Risk (VaR) calculation?

    A linear exposure in the value-at-risk, or VaR, calculation is represented by positions in stocks, bonds, commodities or ... Read Full Answer >>
  2. How does the risk of investing in the aerospace sector compare to the broader market?

    Investing in the aerospace sector is riskier than investing in the broader market. The most accurate measure of sector volatility, ... Read Full Answer >>
  3. Do any markets not exhibit asymmetric information?

    Asymmetric information, when interpreted literally, means that two parties to an economic transaction have different information ... Read Full Answer >>
  4. Can small investors buy collateralized mortgage obligations (CMOs)?

    Collateralized mortgage obligations (CMOs), which are pools of mortgage-backed securities (MBS), are available to smaller ... Read Full Answer >>
  5. What are the benefits of using ceteris paribus assumptions in economics?

    Most, though not all, economists rely on ceteris paribus conditions to build and test economic models. The reason they do ... Read Full Answer >>
  6. How do no-load funds typically perform relative to load funds?

    No-load mutual funds are pooled investments that do not carry an upfront sales charge when purchased or a deferred sales ... Read Full Answer >>
Related Articles
  1. Fundamental Analysis

    The Illusion Of Diversification: The Myth Of The 30 Stock Portfolio

    Find out what it takes to really diversify your portfolio.
  2. Investing Basics

    Asset Allocation: The First Step Toward Profit

    Understanding the different asset classes is an essential part of portfolio diversification.
  3. Investing Basics

    Diversify Your Strategies, Not Your Assets

    Asset classes are intentionally self-limiting, and their use is incapable of creating true portfolio diversification.
  4. Mutual Funds & ETFs

    Financial Advice With Zero Return

    Discover how a recent study indicates that many advisors do not increase investment returns.
  5. Fundamental Analysis

    The Role Of Rebalancing

    A disciplined rebalancing practice can add a lot of value to a long-term strategic asset allocation program.
  6. Active Trading

    When Geographic Diversification Fails

    Geographic diversification is becoming an ineffective investing strategy, but there are others that pay off in the long term.
  7. Economics

    What is Deadweight Loss?

    Mainly used in economics, deadweight loss can be applied to any deficiency caused by an inefficient allocation of resources.
  8. Economics

    How to Do a Cost-Benefit Analysis

    The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.
  9. Stock Analysis

    Is 21st Century Fox a Sly Bet?

    An in depth look at the revenue streams of international media conglomerate Twenty-First Century Fox.
  10. Investing

    Financial Gifts For Grads: Kindergarten To College

    If you really want to help your grad preparing for the future, consider a present that supports their long-term goals—an early start to financial planning.

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Productivity

    An economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in ...
  3. Variance

    The spread between numbers in a data set, measuring Variance is calculated by taking the differences between each number ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as ...
  5. Rule Of 70

    A way to estimate the number of years it takes for a certain variable to double. The rule of 70 states that in order to estimate ...
  6. Risk Premium

    The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is ...
Trading Center