Risk Budgeting and Risk Parity

In a typical 60/40 stock and bond portfolio, stocks make up 60% of the money but contribute around 90% or more of the risk, because stocks are far more volatile than bonds. Risk budgeting flips the question: instead of deciding how much money goes into each asset, decide how much risk each should contribute, and size positions to match. Risk parity is the special case where every asset contributes equally. The approach was popularised by Bridgewater's All Weather fund in the 1990s and spread widely after 2008.

Dollar allocation versus risk allocation#

Risk budgeting#

A risk budget assigns each asset or strategy a share of total risk:

Weights are then solved so that each asset's risk contribution matches its budget. Equal budgets give risk parity.

Leverage in risk parity#

A risk parity portfolio heavy in bonds has low volatility and low expected return. To reach a target such as 10% volatility, risk parity funds typically apply leverage, often through futures. In the example above, reaching 10% volatility from 5.3% would need about 1.9 times leverage. This makes risk parity sensitive to borrowing costs and to periods when bonds and stocks fall together. See Leverage and Futures Trading.

Why investors like it#

• Balanced exposure to different economic environments: growth, recession, inflation and deflation.
• Less dependence on stocks alone.
• No return forecasts needed: only volatilities and correlations, which are easier to estimate than expected returns. See Modern Portfolio Theory and the Efficient Frontier.
• Historically higher risk adjusted returns in many backtests, though results depend on the period.

Drawbacks#

Risk budgeting beyond asset classes#

The same idea applies to strategies and traders: allocate a risk budget to each strategy or desk, measured by volatility or value at risk, and size them accordingly. A strategy with a higher expected Sharpe ratio might receive a larger budget. See Value at Risk (VaR) and Risk, Position, Loss and Drawdown Limits.

Implementation steps#

1. Estimate volatilities and correlations from recent data. See Covariance and Correlation.
2. Set risk budgets for each asset or strategy.
3. Solve for weights so risk contributions match budgets.
4. Apply leverage, if needed, to reach a target volatility.
5. Rebalance as volatilities and correlations change. See Rebalancing.

Frequently asked questions#

What is risk parity?#

A portfolio approach where each asset contributes an equal share of total risk, rather than holding equal amounts of money.

Why does risk parity use leverage?#

Because balancing risk usually means holding many low volatility assets like bonds, leverage is used to raise returns to a desired level.

Why did risk parity struggle in 2022?#

Stocks and bonds fell together as inflation and interest rates rose, removing the diversification the approach relies on while leverage magnified losses.

Next, learn the theory that started it all in Modern Portfolio Theory and the Efficient Frontier.