Risk Parity: An Alternative Way to Build a Portfolio

The 60/40 portfolio, discussed earlier in this module, splits your money this way: 60% in stocks and 40% in bonds. Risk parity takes a different approach. Instead of asking how much money to invest in each asset class, it focuses on the amount of risk each should contribute to the overall portfolio. The goal is to make those risk contributions equal across all assets. This difference is important. Stocks are usually much more volatile than bonds. Even in a classic 60/40 portfolio, where bonds take up a significant 40% of the dollar amount, stocks' higher volatility often leads them to dominate the portfolio's risk. It's estimated that more than 90% of a traditional 60/40 portfolio's total volatility comes from stocks, despite bonds having that substantial 40% share.

Risk parity tackles this issue head-on, often using leverage on lower-volatility assets like bonds. This approach boosts a lower-volatility asset's dollar exposure beyond 100% of the available unleveraged capital. The aim is to raise its risk contribution to match the risk from higher-volatility assets like stocks. The outcome is a portfolio where risk is spread more evenly among the asset classes, rather than allowing one class to overwhelm total risk, even when the dollar amounts seem balanced.