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What is the risk parity strategy? How can this approach reduce investment risks?
The risk parity strategy is an approach to portfolio construction that promises reduced risk. Unlike other theories, the risk parity strategy focuses on risk allocation, prioritizing low-risk assets.
Find out more about the risk parity strategy below.
The Risk Parity Strategy, Explained
Popularized by Ray Dalio, the founder and principal of the successful hedge fund Bridgewater Associates, “risk parity” involves taking long positions in low-risk assets—even borrowing money to do so—to increase returns. The theory underlying this strategy is that low-risk assets often boast higher returns than their risk level would indicate and that high-risk assets are often overpriced.
There are several ways to develop a risk parity portfolio, all involving buying low-risk assets on margin. For example, an investor might borrow to invest in low-beta stocks or bonds. Of course, by borrowing, an investor increases his or her risk—but he or she also increases returns. An investor who bought only bonds between 2007–2016, 50% on margin, would have produced returns just under 2% better than the S&P 500 with slightly less volatility. (This example assumes no cost of borrowing, however.)
The Risk Parity Strategy and the 60/40 Portfolio
A baseline allocation for institutional portfolios—for example, retirement or pension funds—is 60% common stock, 40% bonds. The 60/40 portfolio aims to net investors the higher returns of the stock market while insuring them against market corrections with the consistency of bonds.
However, using a risk parity strategy, investors might be able to achieve greater returns with the same level of risk as a 60/40 portfolio. The way to do this is to create a portfolio whose stock/bond allocation has the same risk and return as the “riskless” rate (in other words, the interest rate on a Treasury bill), and then buy that portfolio on margin. By buying on margin, one can increase volatility to the point where it’s the same as a 60/40 portfolio but with better returns.
Another way to achieve risk parity and outearn a 60/40 portfolio is to invest in a wider array of assets. For example, Bridgewater Associates includes real estate assets (REITs), Treasury inflation-protected securities (TIPS), and other products in its portfolios. As long as these additional assets are negatively correlated—that is, they increase the diversification of the portfolio—then risk is further minimized.
Does a Risk Parity Strategy Work?
The recent evidence has been positive, if not overwhelming, for risk parity portfolios. In a comparison between Bridgewater Associates’ All Weather Fund—the most prominent risk parity fund—and a variety of index funds, the All Weather Fund came in with slightly lower returns than S&P 500 and total market index funds, but it also had less volatility. (Its Sharpe Ratio was 0.51.)
If the options for increasing risk are buying more high-risk assets (in other words, small-cap or growth stocks) or investing in low-risk assets on margin, Malkiel is in favor of the latter because it promotes better diversification. However, borrowing to invest comes with its own set of risks, and only high-net-worth investors, with the means to absorb losses, should really consider a risk parity strategy.
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