Risk Parity strategy

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Risk Parity strategy

Joshua Davis – Michigan University

Risk Parity is a portfolio allocation strategy that focuses on lowering risk without sacrificing expected returns. The strategy asserts that when allocation of assets are leveraged or deleveraged to the same risk level, the portfolio as a whole will be more resistant to market downturns and economic slumps than the traditional portfolio allocation strategy based on capital (60/40 rule). The risk parity approach allows investors to target specific risk levels and spread that level of risk across all assets in the portfolio in order to achieve and optimal amount of diversification. Risk parity usually considers four different components: equities, credit, interest rates, and commodities, and acts to spread risk evenly amongst such asset classes. The problem with the traditional 60/40 portfolio is that it will, on average, attribute 80 to 90% of its risk allocation to the equity class assets. Therefore expected returns will be very volatile to the equity markets. Thus the 60/40 approach may work well in bull markets and times of growth but will often fail in bear markets and economic slumps. The goal of the risk parity approach is to earn the same level of return with less volatility involved and to even obtain better returns with an equal amount of risk and volatility. Use of risk parity aims to balance a portfolio to perform well under multiple economic and market conditions. The success of the risk parity approach is often view through the Sharpe Ratio, which shows the average returned in excess of the risk free rate (rate on assets such as T-bills) per unit of risk/volatility. Implementing a risk parity strategy to your portfolio will reduce risk in a fluid market and will likely lead to the ultimate goal of portfolio management: a high alpha



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