Practical Applications of Risk Parity Optimality
Research originally published in The Journal of Portfolio Management, Vol. 41. No.2.
A risk-parity portfolio can beat actively or passively managed portfolios more than 50% of the time, according to this research. The authors explain how a risk-parity asset allocation strategy–which ignores expected returns and correlations–actually works, and under what conditions. They present their theoretical framework, explain their reasoning and provide empirical support using the returns of stocks and bonds.
- It outperforms. A risk-parity portfolio can outperform an equally weighted portfolio, a passive market portfolio or any other market portfolio more than 50% of the time.
- It requires leverage. Risk parity works only if the institutional investor can leverage up to improve overall portfolio returns.
- It is easier to structure. A risk-parity strategy requires less data and less-sophisticated modeling than other portfolio construction methods.
Practical Applications Report
Risk parity is a popular portfolio allocation strategy that weighs assets inversely proportionally to their risk. But the reason it works was a bit of a mystery before this paper, says Philip Maymin, Associate Professor of Finance and Analytics at the University of Bridgeport’s Ernest C. Trefz School of Business. “Risk parity works. Many funds offer it, and many portfolio managers are talking about it. But no one really understands why it works!”
Typically, investment information about asset selection includes the manager’s view on expected returns, risk and correlation. But risk parity completely ignores both expected returns, and correlations.