Risk Parity Strategy: How Does It Work?

Methods of diversifying portfolios seek to achieve high returns with minimal risks by distributing trading capital across multiple markets and securities. Simply put, this risk-handling strategy suggests putting your eggs in different baskets by distributing trading capital across versatile securities. The risk parity strategy is a renowned diversification method that can be used to spread risk effectively.

What Does Risk Parity Strategy Mean?

Risk parity is a strategy aimed at diversifying a portfolio. It focuses on risk management and investing in asset categories with higher-than-risk returns. Most strategies involve stable assets like treasury bonds and gold, which have proven durable, ensuring a trader’s portfolio provides steady profits and resilience.

The risk parity strategy distributes risks across various instruments, ensuring no security is highly risky, thereby reducing portfolio losses and maximising returns by finding trading instruments that do not correlate with each other.

This trading strategy involves trading various markets like bonds, stocks, cryptos, and commodities, but it suggests that assets respond differently to different scenarios.

When using a risk parity trading strategy, consider two factors: low-risk securities yield higher returns than high-risk securities, and leverage trading profits must exceed regular trading profits without leverage.

The risk parity strategy involves three key elements:

1. Risk factor. It refers to factors contributing to the portfolio’s risk level, such as market position losses, interest rate fluctuations, and other related factors.
2. Class of asset. This factor implies picking assets based on their risk to the portfolio rather than their value or expected returns. The instrument selection includes commodities, stocks, hedge funds, and more.
3. Diversification. This element involves investing in versatile markets and assets from various countries to mitigate the impact of national economic shocks or singular economic slumps.

The risk parity strategy is tailored to each trader’s preferences and risk level. However, diversifying assets by market and geography is crucial.

Risk parity offers several benefits, including diversification, low cost, and safety during recessions. Investing a smaller portion of the portfolio in various assets, such as bonds, commodities, risk-free assets, and stocks, increases the chances of good returns even during lower market performance.

Types of Risk Parity Portfolios

There are two main types of risk parity portfolios: an all-weather portfolio and a permanent portfolio.

An all-weather portfolio was suggested by Ray Dalio, founder of Bridgewater. This portfolio is less actively managed, earning a passive return and having a lower fee structure, making it popular among those who can’t afford heavy investment management fees. During the 2007 financial crisis, these portfolios performed better than stock-heavy ones. 

Dalio’s approach includes assets not significantly affected by economic periods like inflation, deflation, growth, and downturn.

Assets and securities remain flexible amidst economic changes, requiring the following distribution of resources:

• 30% of U.S. stocks
• 40% of  long-term Treasury bonds
• 15% of intermediate-term Treasury bonds
• 7.5% of commodities
• 7.5% of gold

A permanent portfolio strategy suggested by Harry Browne is a portfolio consisting of long-term assets with upward movement and short-term fluctuating assets. This method implies a structured distribution of assets in the portfolio:

• 25% U.S. stock
• 25% long-term U.S. Treasury bonds
• 25% short-term U.S. Treasury bonds
• 25% gold

Both strategies recommend Treasury Bonds and equities as safe investment options due to their stable income stream and minimal price fluctuations, making them a safer choice than stocks or commodities.

Final Words

Risk parity strategies also have disadvantages. Market timing risk can lead to investments going beyond prescribed limits, and monitoring is still required, making them more expensive than passive portfolios. A greater amount of leverage is required to generate similar returns, but this is a trade-off for lower risk. Additionally, higher allocation to cash is necessary to meet periodic payments to leverage providers and margin calls, which can be a limitation as cash securities earn little or no return.