How it works
Risk parity allocates by RISK contributed rather than dollars committed: instead of 60% of capital, stocks get whatever weight makes them contribute 60% of... nothing — the point is EQUAL risk contributions from every sleeve. Full implementations solve constrained optimizations; this sketcher uses the classic shortcut, inverse-volatility weighting, where each asset's weight is proportional to one divided by its volatility. Low-vol bonds consequently dominate capital — an 18/6/15 trio lands near 17/52/31 — because equalizing risk from calm assets requires owning much more of them. The result is estimated with a uniform-correlation approximation of portfolio variance, set against a static 60/40 of the same ingredients so the diversification effect has a reference point. Honest caveats belong in every sentence about this approach: inverse-vol weights only approximately equalize risk contributions when correlations differ; unlevered versions accept lower EXPECTED returns than stock-heavy mixes (true institutional parity levers bonds up); and a single average-correlation number flattens the correlation spikes that define crises. Treat output as a thinking scaffold for allocation conversations, not a tradable recipe.
Formula
wi ∠1/σi (normalized) | σp² ≈ Ï(Σ wiσi)² + (1−Ï) Σ wi²σi² | Compare against 60/40 of the same assets
Tips
- Expect bond-heavy weights — that IS the strategy, not a bug.
- Unlevered parity trades expected return for smoother rides; size expectations accordingly.
- Test correlation spikes: raise the average to 50% and watch the advantage shrink.
- Real risk parity optimizes contributions; treat inverse-vol as its quick cousin.
- Rebalance periodically — volatilities drift and weights follow them.
Frequently asked questions
- What is risk parity investing in simple terms?
- Allocating so each asset contributes EQUALLY to portfolio risk instead of allocating capital equally. Because bonds wiggle far less than stocks, that means owning much more of them — often 50–70% — sometimes with leverage lifting returns back up. The goal is a smoother, more balanced ride.
- How do inverse-volatility weights work?
- Each weight equals one over the asset's volatility, normalized across holdings. Stocks at 18% vol and bonds at 6% produce a 1:3 raw ratio — 25/75 before adjustments. It approximates equal risk contribution when correlations are similar and is the standard quick proxy for full parity optimization.
- Why do risk-parity portfolios hold so many bonds?
- Because risk, not dollars, is being balanced. Bonds at 6% volatility carry a third of stocks' 18%, so equalizing contributions requires several times their capital — often 50–70% of the portfolio. Institutional versions then borrow to scale returns back up; unlevered versions accept lower expected growth.
- Did risk parity work in 2022 when stocks and bonds fell together?
- Poorly — the strategy leans on negative stock/bond correlation that flipped positive as rates spiked, and classic parity mixes drew down on the order of 15% (illustrative). It cushioned equity crashes historically but cannot protect against synchronized inflation-driven selloffs; correlation assumptions are the fragile ingredient.
- Is inverse-vol weighting the same as true risk parity?
- Not exactly. True parity solves for weights making each asset's marginal risk contribution equal; inverse-vol approximates that quickly. An 18%-vol stock against 6%-vol bonds gets a 1:3 raw ratio either way, but results diverge when pairwise correlations differ widely — close cousins, not twins.