Risk Parity

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.

BREAKING DOWN '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. Portfolio

    A grouping of financial assets such as stocks, bonds and cash ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments ...
  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. Green Fund

    A mutual fund or other investment vehicle that will only invest ...
Related Articles
  1. Trading Strategies

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
  2. Fundamental Analysis

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

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

    Asset Allocation: The First Step Toward Profit

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

    Diversify Your Strategies, Not Your Assets

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

    Financial Advice With Zero Return

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

    The Role Of Rebalancing

    A disciplined rebalancing practice can add a lot of value to a long-term strategic asset allocation program.
  7. 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.
  8. Mutual Funds & ETFs

    3 AllianceBernstein Funds that Are Rated 5 Stars by Morningstar

    Discover the top three mutual funds administered and managed by AllianceBernstein that have received five-star overall ratings from Morningstar.
  9. Mutual Funds & ETFs

    Top 4 Davis Funds for Retirement Diversification in 2016

    Discover the four best mutual funds managed by Davis Advisors that pursue different investment strategies that can help diversify retirement portfolios.
  10. Mutual Funds & ETFs

    Is Morningstar’s Star System An Effective Ranking Tool? (MORN)

    Learn why Morningstar's star rating system is not always a great predictor of future performance, and why investors should not pick funds on star ratings alone.
RELATED FAQS
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  3. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  4. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  5. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
  6. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  6. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
Trading Center