Risk Parity: An Alternative Way to Build a Portfolio

The 60/40 portfolio, covered elsewhere in this module, allocates by DOLLAR amount: 60% of total capital in stocks, 40% in bonds. Risk parity starts from a genuinely different organizing question: instead of asking how many dollars to put in each asset class, it asks how much RISK each asset class should contribute to the overall portfolio — and then builds the allocation specifically to make those risk contributions roughly equal across assets. This distinction matters enormously in practice, because stocks are typically far more volatile than bonds. Even in a traditional 60/40 portfolio, where bonds represent a substantial 40% of the actual dollar allocation, stocks' much higher volatility means they typically end up dominating the portfolio's ACTUAL RISK — commonly estimated at 90% or more of a traditional 60/40 portfolio's total volatility coming specifically from its stock holdings, despite bonds' seemingly substantial 40% dollar share.

Risk parity addresses this imbalance directly, typically through the use of leverage on lower-volatility assets like bonds — effectively increasing a lower-volatility asset's dollar exposure beyond 100% of unleveraged available capital, specifically so its risk contribution can rise enough to genuinely match the risk contribution coming from higher-volatility assets like stocks. The result is a portfolio where, rather than one asset class dominating total risk despite a seemingly balanced dollar allocation, risk itself is genuinely spread more evenly across the included asset classes.