Risk Parity

What is Risk Parity?

Risk parity approach is a method of portfolio creation in which the amount invested in various assets in the portfolio is determined based  on the quantum of risk that security brings to the portfolio and the ultimate goal is to ensure that each asset contributes equally to the overall risk of the portfolio.

Explanation

We look at the risk-adjusted returns while creating a portfolio, keeping in mind the constraints, the return requirement, and the risk tolerance of the investor. However, in the risk parity approach, we allocate only that much amount of money in an asset, which makes the risk of the investment equal to that of the other investments in the portfolio and meets the risk tolerance as specified in the Investor Policy Statement (IPS)

Sometimes this approach is also known as the ‘Risk premia parity’ method, and the proponents believe it of this approach that the Sharpe ratioSharpe RatioSharpe Ratio, also known as Sharpe Measure, is a financial metric used to describe the investors’ excess return for the additional volatility experienced to hold a risky asset. You can calculate it by, Sharpe Ratio = {(Average Investment Rate of Return – Risk-Free Rate)/Standard Deviation of Investment Return} read more of such a portfolio is higher as compared to a portfolio that doesn’t follow this approach.

Risk Parity

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How Does Risk Parity Work?

  • Traditionally, the investment portfolio consists of approximately 60% stock and 40% in fixed income investments. Therefore the maximum risk, almost close to 90%, comes from the investment in stock, and so does the return. In a Risk parity approach, if the asset has a high-risk, high return profile, then the investment in the same is slightly lower, and more increased investment goes to purchases with low-risk short return profiles.
  • The overall aim is to maximize the Sharpe ratio, so even if the numerator is smaller, the denominator is even smaller because that is the risk of the portfolio, so the overall Sharpe ratio is higher. Following smart art shows the direction in which the portfolio bends in the risk parity approach to strike a balance between riskier and less risky assets:
Risk Parity Working

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Example of Risk Parity Portfolio

Let us understand with an example.

You can download this Risk Parity Excel Template here – Risk Parity Excel Template

We can take a simple two asset portfolio and do a few calculations to show how the risk parity approach can give a better Sharpe ratio than the traditional portfolio:

Example 1

Solution:

For Traditional Portfolio

Portfolio Return

Portfolio Standard Deviation

Risk party (SD)

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Portfolio Standard deviation =

Risk party (SD value) = 14.107%

Risk Contribution = Weight of Asset * Standard Deviation of Asset

  • Stock Risk contribution = 0.60 x 22 = 13.2%
  • Bond Risk contribution = 0.40x 6= 2.4%
Risk Parity Example 1-1

For Risk Parity Portfolio

Portfolio Return

  • Portfolio Return = 0.2143 x 18% +0.7857 x 8% =10 %

Portfolio Standard Deviation

Formula= 67%

Risk Contribution = Weight of Asset * Standard Deviation of Asset

  • Stock Risk Contribution = 0.2143 x 22 = 4.71%
  • Bond Risk Contribution = 0.7857 x 6 = 4.71%
Example 1-2

So we can see that the risk parity approach has a higher Sharpe ratio, even with a lower portfolio return

Benefits

Limitation

Opponents of this approach point out that not all that glitters is gold; they say that even though the risk is lower, it is not eliminated:

  • Market timing risk: Risk Parity portfolios face the risk of market timing because the risk or volatility of the invested asset may not always remain constant. Therefore, it might be the case that the risk goes beyond the prescribed limits, and the portfolio manager is not able to pull out investment promptly.
  • Monitoring: Even if active management is not required as much as it is in the case of a more traditional portfolio, rebalancing and monitoring are still needed. Therefore the costs of such portfolios are even higher than completely passive portfolios, which require almost negligible portfolio management.
  • Leverage: Greater amount of leverage is required to generate a similar return compared to the traditional portfolio management. However, it is a trade-off to create lower risk, and therefore it is up to the investor to choose.
  • Higher allocation to cash: The greater need for leverage requires more cash in hand to meet periodic payments to the leverage providers and meeting margin calls. This is a limitation because cash or nearly cash securities earn very little or no return.

Conclusion

Therefore, we can say that the Risk parity approach is a portfolio management technique in which the capital is allocated among various assets so that the risk contribution of each asset is equal, and therefore, this approach is so named.

It is advocated that this approach leads to a higher Sharpe ratio, which implies a higher risk-adjusted returnRisk-adjusted ReturnRisk-adjusted return is a strategy for measuring and analyzing investment returns in which financial, market, credit, and operational risks are evaluated and adjusted so that an individual may decide whether the investment is worthwhile given all of the risks to the capital invested.read more; however, leveraging in achieving such an allocation might lead to excessive cash component. And the absolute returnAbsolute ReturnAbsolute return refers to the percentage of value appreciation or depreciation of an asset or fund over a certain period. Such assets include mutual funds, stocks and fixed deposits.read more is lower. So the investor needs to have a clarity that if he is forgoing return, he is doing so to have a less risky portfolio and is okay with this approach.

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