By Tianyin Cheng
The principles behind risk parity relate to answering a deceptively straightforward question: What is diversification? Traditionally, investors have allocated their capital among multiple asset classes to achieve diversification, such as the 60/40 equity/bond blend. Such an approach leads to a disproportionate allocation of risk across asset classes, with equities taking up most of the risk allocation.
A risk parity strategy aims for balanced risk contribution from all asset classes. We understand that asset class returns are generally proportional to the risk taken (according to Capital Market Pricing Model) and that a diversified portfolio consisting of relatively uncorrelated assets may reduce risk without foregoing return. Different economic cycles also expose different asset classes to different levels of risk. Risk parity strategies take these factors into account and aim to balance risk contribution from a mix of assets and apply leverage to the overall portfolio, which can help to meet the twin challenges of achieving higher returns, while reducing risk in a diversified portfolio.