All investors seek a balance between risk and return that works for their temperament and circumstances. Allocation of capital drives many investment strategies, but some focus on risk allocation instead. One such strategy is risk parity, which spreads risk across asset classes to deliver returns that don’t swing up and down with the market. This approach can appeal particularly to investors who want to avoid concentrating their portfolio risk in stocks. While it’s a popular strategy, you may want to consider working with a financial advisor to determine if it suits your investment approach.
Risk Parity Explained
Risk parity is an investment strategy that aims to spread risk exposure equally across every type of portfolio asset. It aligns with modern portfolio theory (MPT) by trying to maximize returns while adhering closely to the investor’s risk tolerance. However, risk parity adjusts for risk first and assumes good returns will follow, with some portfolio rebalancing and leverage along the way. The goal is to ensure no one asset is especially high risk and likely to drive down the value of the portfolio. Properly monitored, the strategy should create steady returns that are competitive with or superior to the MPT approach.
A risk parity portfolio can include many types of investments. Managers can choose bonds, stocks, commodities, and other types of assets with uncorrelated returns. The key is assembling assets that perform differently under the same conditions, with some rising, others dropping in value.
Conventional Allocation Portfolio vs. Risk Parity Portfolio
Investors often default to the 60/40 method of asset allocation, with 60% of the portfolio in stocks and 40% in bonds. It’s a convenient investment method that is fairly simple to rebalance when market conditions change. The downside can come with performance. Long term, 60/40 portfolios generally do not perform as well as those more concentrated in stocks.
Risk parity attempts a more advanced method of portfolio management. The investor must first decide what level of risk exposure they can tolerate. Then, instead of opting for a default high/low-risk allocation, the manager balances assets to achieve the target risk across the entire portfolio. Typically they will buy more low-risk and less high-risk assets, to create an even, overall risk exposure.
Investors often use some MPT methodology to design risk parity portfolios, but there is a an important difference between these approaches. MPT creates a portfolio mix based on the potential for both risk and return. In contrast, at the outset the risk parity approach focuses solely on risk distribution.
Naturally, the investor’s desired return is a factor in any portfolio management. But the theory holds that dispersed risk should lead to better performance. In particular, risk parity should create a buffer between the portfolio and bear markets. The portfolio should keep steady when equities drop in value because the risk does not concentrate in the equity class. By contrast, a conventional portfolio’s risk may pile up to 90% of its risk into equities. So when the market drops, so does the portfolio’s performance.
The Benefits of Risk Parity Investing Strategies
The biggest advantage of using risk parity is its potential to realize incremental returns through diversity and smart rebalancing. Portfolio managers can select from a variety of assets instead of sticking with just two. The more diversified the assets are, the more value investors can create through rebalancing.
Risk parity investors select assets based on their diversification advantages and often use leverage-borrowed money-to achieve the target risk level. When it involves leverage, the strategy does become more difficult for traditional investors, who generally don’t borrow to fuel their investment strategy. Typically, this part of the strategy only works for institutional investors, such as pension plans or mutual funds, that have plenty of investment capital. However, individuals can invest in funds and plans that take a risk parity approach.
Another advantage is that risk parity strategy can work at any level of risk. Whether an investor has high risk tolerance and a long time horizon or the exact opposite, the same risk distribution strategy applies.
Advocates point to evidence that suggests long-term performance of risk parity strategies compares favorably with 60/40 portfolios. However, most of the evidence assumes leverage is part of the risk parity equation. Without it, these types of strategies do not perform as well.
The Disadvantages of Risk Parity
Like any other investment method, risk parity has its downside and detractors. One potential disadvantage is that it commonly leverages low-risk assets, such as bonds, to counterbalance risk in other asset classes. This may create an imbalance in the portfolio. And while bonds performed fairly well in the last few years, they may not do as well in the current interest rate environment.
Critics also point to the strategy’s reliance on leverage. Risk parity can deploy leverage in various forms, such as futures contracts and repurchasing agreements. With a 10% risk target, investment managers may carry at least 200% of collective exposure at one time. Portfolios may require this amount of leverage to offset the low-risk assets.
Even if leverage itself is not problematic, not all portfolio managers have operational experience managing it. Leverage can be critical to achieving the proper risk equivalence across the portfolio’s assets, and it correlates to higher returns. But if a manager does not manage leverage effectively, it could cause liquidly problems for the investor.
Risk parity attracts investors who believe more sophisticated and diverse portfolios can generate strong returns, especially during market downswings. It depends heavily on redistribution of assets and, in many cases, the extra power of leverage to avoid over-reliance on one particularly risky asset category, like stocks. That makes the strategy somewhat better suited to institutional investors. That said, individuals can buy into funds that take the risk parity approach.
Tips for Investors
- Before considering an investment strategy, it makes sense to understand your risk tolerance and the level of return you expect. It also helps to assess how much maintenance and rebalancing you’re prepared to do. A hands-on approach and regular engagement is important to this strategy.
- It’s a smart move to seek financial advice when you are investing for the long term. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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