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.
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Source: Risk Parity (wallstreetmojo.com)
How Does Risk Parity Work?
- Traditionally, the investment portfolio consists of approximately 60% stock and 40% in fixed income investmentsFixed Income InvestmentsFixed income investment is a type of investment in which the investor receives a fixed and relatively stable stream of income in the form of dividends or interest over a period of time. Companies and governments typically issue fixed investments in the form of debt securities.read more. 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:
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Example of Risk Parity Portfolio
Let us understand with an example.
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:
Solution:
For Traditional Portfolio
Portfolio Return
- Portfolio Return FormulaPortfolio Return FormulaThe portfolio return formula calculates the return of the total portfolio consisting of the different individual assets. The formula is computed by calculating the return on investment on individual asset multiplied with respective weight class in the total portfolio and adding all the resultants together. Rp = ∑ni=1 wi riread more = weighted average of returns = 0.60 x 18% + 0.40 x 8% = 14%
Portfolio Standard Deviation
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- The rho symbol is the coefficient of correlationCoefficient Of CorrelationCorrelation Coefficient, sometimes known as cross-correlation coefficient, is a statistical measure used to evaluate the strength of a relationship between 2 variables. Its values range from -1.0 (negative correlation) to +1.0 (positive correlation). read more between the two assets
Portfolio Standard deviationPortfolio Standard DeviationPortfolio standard deviation refers to the portfolio volatility calculated based on three essential factors: the standard deviation of each of the assets present in the total portfolio, the respective weight of that individual asset, and the correlation between each pair of assets of the portfolio.read more =
= 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%
For Risk Parity Portfolio
Portfolio Return
- Portfolio Return = 0.2143 x 18% +0.7857 x 8% =10 %
Portfolio Standard Deviation
= 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%
So we can see that the risk parity approach has a higher Sharpe ratio, even with a lower portfolio return
Benefits
- Diversification: In the Risk Parity approach, a smaller portion of the investment is made in all kinds of assets such as stock, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, commodities, treasury inflation-protected securitiesTreasury Inflation-protected SecuritiesTreasury inflation-protected securities (TIPS) are inflation-indexed bonds issued by the US government. Since its principal is indexed to the US consumer price index, it provides a hedge to the inflation risk. With increasing inflation, TIPS's principal values also rise, hedging the bond's inflation risk.read more, risk-free assets, and so on. This increases the chances of a good return even in times of lower stock market performance. Therefore, the very first such portfolio was known as the ‘All-weather’ fund and was started in 1996.
- Low cost: Such portfolios are less actively managed and therefore earn a passive return. The fee structure is lower; therefore, those who can’t afford heavy investment management fees prefer such portfolios. The clientele mostly consists of safe return seekers and, therefore, lower risk toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more, such as pensioners.
- Safer in Recession: When the economy faces the recessionary headwinds, such portfolios can bear it better than a traditional portfolio, which is heavily invested in stocks and other riskier assets. Such funds have lower chances of losing value because the diversified pool can give a cushion to the return and prevent it from falling too much. During the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more of 2007 and for a few years post that, this portfolio gave better performance compared to stock-heavy portfolios.
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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