- Investors are typically counseled to diversify capital across asset classes in order to reduce risk.
- In light of this, it may be a surprise to learn how concentrated the risk sources of a traditionally diversified portfolio may be.
- Risk parity -- the concept of achieving diversification by sources of risk -- is gaining wider attention.
- While there are numerous risks involved with investing, "risk", as we refer to it here, means volatility or standard deviation.
“Risk parity” is an investment strategy that seeks to balance the sources of risk in a portfolio. The easiest way to envision this concept may be to consider it in the context of a traditional, diversified portfolio. For many investors, this portfolio is represented by defined percentage allocations across stocks and bonds. Such a balanced portfolio, for example, will often allocate 50% of its assets to stocks and 50% to bonds in an effort to achieve diversification. However, research indicates that this equal allocation of investment capital does not necessarily equate to being diversified by risk.
This is because stocks tend to exhibit four-to-five times more volatility than bonds. So, while the weighting of a balanced portfolio appears to be even and equal, the investment in equities carries significantly greater risk than the investment in bonds. Exhibit 1 highlights the disparity.
Risk Parity: Balanced Risk
Risk parity investment strategies seek to diversify sources of risk. Each source of risk carries a risk premium, which is a potential source of return. In order to achieve this diversification, these strategies assume that asset classes (such as stocks and bonds) should contribute equally to the level of risk in a portfolio. For example, based on volatility over the past 20 years, a portfolio would only need to allocate 19% to U.S. stocks and 81% to U.S. bonds to make the contributions to risk equal, as seen in Exhibit 2.
Risk Parity: Beyond the Basics
At the simplest level, a risk parity portfolio seeks to achieve equal contributions to risk across various asset classes. In addition, risk parity strategies tend to allocate beyond stocks and bonds in an effort to provide upside growth and downside mitigation through various economic scenarios, as shown in Exhibit 3 below.
For example, a hypothetical risk parity strategy may include global stocks, in addition to domestic stocks for growth-oriented environments and inflationsensitive assets (i.e., commodities) for inflationary environments. These assets are not always accounted for in less-diversified portfolios. Once the asset-class allocations are established, some managers maintain equal contribution to risk by monitoring the short-term volatility of each asset-class bucket and actively rebalancing the portfolio’s exposure based on rising or falling volatility. When the volatility of an asset rises, its contribution to risk is maintained by reducing its allocation in the portfolio. If all assets experience an increase in volatility (as in the 2008 credit crisis), exposures across each bucket will be reduced and the assets shifted to cash.
Proponents of risk parity believe that a balanced risk allocation can produce more consistent returns than a traditional capital-allocated portfolio over time. The benefits of the strategy include reduced allocations to and reliance on the stock market generally, a more diversified set of exposures during varying economic scenarios and the potential for enhanced risk/return characteristics.
No investment strategy is without risk. Seeking to allocate assets in a way that keeps one asset class from dominating performance can be beneficial for risk-management purposes. However, portfolios genuinely diversified by risk can experience large performance differentials relative to more traditional portfolios “balanced” by capital allocation. Though we fully expect diversified portfolios to outperform concentrated ones, these expectations may not be realized over any given finite period. While allocating more dollars to lower-volatility asset classes would seem to reduce both the expected risk and the expected return profile of a portfolio, risk parity managers typically address this by targeting a level of volatility similar to that of a more traditional portfolio. This is accomplished by applying a modest amount of leverage to a diversified portfolio of asset classes. By targeting a similar level of risk, but doing so in a more diversified fashion, risk parity seeks to outperform more traditional portfolios via more efficient portfolio construction.
Standard Deviation is used as a statistical measure of historical volatility. A statistical measure of the distance a quantity is likely to lie from its average value. It is applied to the annual rate of return of an investment, to measure the investment’s volatility (risk). Standard deviation is synonymous with volatility, in that the greater the standard deviation the more volatile an investment’s return will be. A standard deviation of zero would mean an investment has a return rate that never varies.
The Barclays U.S. Aggregate Bond Index (formerly Lehman Brothers U.S. Aggregate Bond Index) is a benchmark index composed of U.S. securities in Treasury, government-related, corporate and securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.
The S&P 500 Index is an unmanaged, market-weighted index that consists of 500 of the largest publicly-traded U.S. companies and is considered representative of the broad U.S. stock market.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of
future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment
advice and is intended for educational purposes only.
There are risks involved with investing, including loss of principal.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI
nor its subsidiaries is affiliated with your financial advisor.