Risk Parity Explained

Risk parity sizes positions so each asset contributes equal risk rather than equal capital, then applies leverage to hit a return target.

Risk parity allocates capital so that every position or asset class contributes an equal share of total portfolio risk, rather than an equal share of total capital, which corrects the concentration problem built into an equal weighted or capitalisation weighted book. A portfolio split 60 percent equities and 40 percent bonds by capital typically carries something close to 90 percent of its risk from the equity sleeve alone, because equities are several times more volatile than bonds, so the bond allocation barely moves the outcome despite looking substantial on paper.

Risk contribution from an asset depends on its volatility, its weight in the portfolio, and its correlation with everything else held. A 60/40 split assigns capital roughly evenly by a simple rule, but it does not assign risk evenly, since equities with an annualised volatility near 15 percent dominate bonds with an annualised volatility near 6 percent even at a smaller capital weight. The result is a portfolio that behaves, in risk terms, much closer to a pure equity position than the headline allocation suggests.

This concentration is not unique to a 60/40 split. Any capitalisation weighted or naively equal weighted portfolio built from assets with meaningfully different volatilities will show the same pattern, since capital weight and risk weight are only the same thing when every asset carries identical volatility and correlation to the rest of the book. A commodities sleeve added to the same portfolio at a small capital weight can end up contributing almost no risk at all, which defeats the purpose of including it as a diversifier in the first place.

For a two asset portfolio, the marginal contribution to risk from each asset can be derived from its weight, its own volatility, and its covariance with the other asset, and true risk parity solves for the weights that equalise those two contributions. With equity volatility of 15 percent, bond volatility of 6 percent, and a correlation of negative 0.2, achieving equal risk contribution requires a capital allocation closer to 25 percent equities and 75 percent bonds, roughly the inverse of the traditional 60/40 split, since bonds need a much larger capital weight to match the risk that equities generate at a small weight.

Naive risk parity approximates this with inverse volatility weighting, sizing each asset in proportion to one divided by its own volatility and ignoring correlation entirely. True risk parity solves the full system including correlation, which matters more as the number of assets grows and correlations shift, but the two approaches usually land close together for a small number of low correlation assets.