Risk Parity: Allocating by Risk

Money split evenly ≠ risk split evenly

The volatility of stocks is about 3 times that of bonds. In a 60/40 portfolio, stocks are only 60% of the money but contribute over 90% of the risk: the portfolio moves almost exactly like stocks.

Risk contribution

risk contribution = weight × how much that asset moves the portfolio's volatility at the margin, and they add up exactly to the portfolio's total risk. When you look at an allocation, check both where the money is and where the risk is.

Risk parity

risk parity makes each asset class contribute the same amount of risk, so low-volatility bonds get more money. The portfolio is steadier but earns less; in practice, moderate leverage is often used to scale it up to a target volatility.

Key takeaways

• Capital weight ≠ risk weight: a volatile asset can contribute most of the risk with only a small share of the money.
• Risk contribution = weight × the asset's marginal effect on portfolio volatility, and all the risk contributions add up to the portfolio's total risk.
• Risk parity puts more money into low-volatility assets (like bonds), giving a steadier portfolio with lower expected return; in practice it's often paired with moderate leverage.
• When stocks and bonds fall together (correlation turns positive), risk parity's diversification weakens noticeably.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Default “60/40 stocks/bonds”: stocks are 60% of the money, so what share of the risk do they carry? What's the portfolio volatility?
2. Switch to “Equal-weighted”: with a third of the money in each asset class, what share of the risk comes from stocks now?
3. Switch to “Risk parity”: how much money goes to stocks, bonds and gold? What are the portfolio's volatility and expected return?
4. Stay on “Risk parity” and raise the stock × bond correlation to 0.8: what's the portfolio volatility now? Compare with the table below: is diversification weaker?

Quiz and explanations

1. 60% stocks / 40% bonds, with stock volatility 18%, bond volatility 6% and correlation 0. Roughly what share of the risk comes from stocks?

Answer: About 95%.Stock variance 0.6² × 18%² ≈ 0.0117, bond variance 0.4² × 6%² ≈ 0.0006, so stocks account for about 95%.

2. With only two asset classes, risk parity weights are inversely proportional to what?

Answer: Volatility.For the two assets to contribute equal risk, the more volatile one gets less money, so weights are inversely proportional to volatility.

3. Stock volatility is 20% and bond volatility 5%. In a two-asset risk parity portfolio, roughly what's the capital weight in stocks?

Answer: 20%.Weight ∝ 1/volatility: 1/20 : 1/5 = 1 : 4, so stocks get 1/5 = 20%.

Terms in this lesson

• correlation (Correlation): How much two prices move together, from −1 to 1; the closer to 1, the more in sync.
• leverage (Leverage): Controlling a large position with a small amount of margin; 1:100 means $1 controls a $100 position.
• risk contribution (Risk Contribution): An exposure's share of the portfolio's total risk, taking its correlations with the other exposures into account.
• risk parity (Risk Parity): Allocating by risk instead of money so each asset class contributes equally to portfolio swings; low-volatility assets like bonds get more money.
• Sharpe ratio (Sharpe Ratio): (Return − risk-free rate) ÷ volatility: how much excess return you earn per unit of risk.
• volatility (Volatility): How wildly the underlying's price swings; the bigger the swings, the more expensive options get.