For any investor, one of the most significant decisions that they need to make is allocating assets in their portfolio. As such, many investors have found themselves looking at risk parity as a potential strategy for investment.
However, there are a number of caveats surrounding risk parity that make this methodology somewhat problematic.
As of 2020, the composition of assets in the average investor’s portfolio worldwide varied according to Statista. In that year, the majority of their investments were allocated to traditional assets (72%) followed by private equity and real estate, both at 10%.
With risk parity, it allows investors the opportunity of risk-adjusted returns that are relative to those portfolios that have a traditional asset allocation – which appears to be the majority. However, despite its appeal, there are some common problems that come with risk parity strategies, problems that need highlighting.
What is risk parity
What is risk parity? Well, in layman’s terms, risk parity is the goal of balancing the contribution of all portfolio risk from each asset class.
Risk parity seeks to disperse the risk found in traditional portfolios that may, for example, consist of a 60% equity and 40% fixed income portfolio.
With a risk parity strategy, there’s the belief of risk and return having this one, constant relationship. As such, it’s assumed that all assets will have similar risk-adjusted returns.
Essentially by balancing the risk within this diversified portfolio, an investor can enjoy fewer fragilities within their investments. Hopefully, returns on their investments can continue to be fruitful in performance.
The relevance of using risk parity
With a strong relationship between bonds and equities, the relevance of using risk parity in these diversified portfolios makes sense to an extent. Certain investments have higher risk factors and so to help counter-balance that high risk, holding lower risk, lower expected return assets like bonds, are assumed to be financially beneficial.
The relevance of using risk parity is that it’s designed with the intention of investors to successfully maintain their portfolios with risk diversification. Through the use of leverage, the investor will hopefully still meet their expected returns.
It all seems like a viable solution to help balance risk, correct? Well, in theory, maybe, but in reality, the outcome may not be as clear-cut.
5 common problems with risk parity strategies
According to one source, at least $100bn has already been invested in risk parity strategies. Before you go jumping on the bandwagon though, it’s important to be aware of common problems that come with using this type of strategy.
1. The strategy ignores asset returns
With how risk-parity strategies are constructed and leveraged, returns on individual asset classes have no involvement when it comes to deciding risk parity allocation.
This seems like a bizarre approach, especially as most investors will agree that returns on investment are often the most important concern.
It’s believed that maybe the reason for ignoring asset returns is that these future returns are purely speculative and don’t hold a guaranteed weight. This is made even more confusing when risk parity is based on correlation and volatility.
It’s suggesting that investors will assume that past volatility and correlations will continue in the future but the same cannot be said for past returns.
2. The use of volatility as a measurement is flawed
It‘s considered that volatility as a measure of risk, is flawed. It’s not an appropriate measure of risk because volatility doesn’t always apply in the same way to asset classes. This volatility can change at any number of times due to a variety of reasons. For example, a recession may have a significant impact on losses but a recession in itself is a rare event.
To use volatility as a measurement for risk is flawed because the parameters that govern assets – aka volatility – are always changing.
This underestimation of how volatility fluctuates can be detrimental to those who use risk parity as a strategy for investments.
3. Risk parity underperforms when risk-adjusted returns vary.
In relation to the first point of risk parity ignoring past returns or future returns in its methodology, risk parity often underperforms when risk-adjusted returns vary.
You may or may not believe that risk-adjusted returns do vary across asset classes but if they do, then this is where a risk parity strategy can end up underperforming as a result.
This strategy relies on leveraging low-risk assets. They end up leveraging these low-risk assets, primarily bonds, to level out the risk from all other asset classes. However, despite its good performance over the years, the current market of today’s interest rate environment may not help the performance of bond ownership in the future.
While a gradual rise in interest rates helps risk parity strategies, a decline doesn’t. It’s important not to put all your trust in bonds being the sole asset to help balance all of the risks out
4. Risk parity portfolios aren’t just risk parity.
It’s important to flag that just because a portfolio has been diversified using risk parity strategies, doesn’t just make it exclusive to risk parity. No investment portfolio is directly the same as another, which means a one size fits all approach doesn’t work. This type of risk model isn’t going to work on solely creating a risk parity portfolio.
Not all investors are taking equal risk across assets so using one unified risk model doesn’t help those who have a variety of risk-adjusted returns within their portfolio.
5. It only works in certain economic situations.
The relevance of risk parity strategies has come under more scrutiny perhaps due to the current economic state that we’re in as of 2022.
In an ideal world, risk parity works when all the conditions are in their favor. When it isn’t, many investors end up losing faith in it. COVID-19 has also added some frictions to global supply chains, which has impacted bond assets. What is risk parity based around? Bonds.
While it may be useful to implement a risk parity strategy, it’s not a strategy that’s the be-all and end-all of diversifying your portfolio. It will only perform best when the assets within the portfolio are all similar in risk-adjusted returns. Where these risks are unequal, risk parity doesn’t perform as well.
Additional tips for diversifying a portfolio to reduce risk and losses
While risk parity isn’t completely flawed in its approach, there are other ways to help diversify a portfolio to help reduce risk and losses.
Use hedging as a security
No, it doesn’t have anything to do with sprucing up your backyard. Hedging your portfolio is to reduce that unsystematic risk. It involves buying or selling an investment to help reduce the risk of loss when in an existing position.
There are a number of hedging strategies worth looking at that can help reduce market risk on your investments.
Include foreign investment into the mix
One problem with risk parity is that it doesn’t factor in foreign investments. Risk-adjusted returns aren’t equal, especially when it comes to foreign currency risk. It’s a risk that investors don’t like to take and as such, foreign investment into currency-based assets may have lower risk-adjusted returns.
Try looking beyond your own country for investments and start looking further afield.
Explore different sectors
Like foreign investment, it’s important to switch up your asset choices by exploring different sectors. Spreading the wealth across different sectors is going to further avoid putting all your eggs (or money) in one basket. From stocks to exchange-traded funds and real-estate investment trusts, there’s a lot to choose from.
Cryptocurrencies and NFTs are just a couple of the latest investment opportunities that may be worth exploring to further diversify your own portfolio. Spreading the risk around is going to help lead to bigger rewards – hopefully.
Be careful not to over-diversify
It seems counter-productive to tell you not to over-diversify when this whole article is aimed at diversifying a portfolio. However, there is validity when it comes to avoiding over-diversifying.
While it is important to diversify, having too many securities can be problematic. Not only that but it can be difficult to manage everything all at once. You could effectively self-sabotage your own efforts as a result. If you own too much of one stock, then it might be worth liquidating it, to then put it in another asset.
Know when to get out
Finally, it’s important to be aware of when investments have peaked or may be heading south. An understanding of the market in relation to all your asset classes can be helpful in staying ahead and getting out before you start losing money.
Avoid using risk parity as a lone investment strategy
While there are some advantages to using risk parity for balancing risk in your investment portfolio, it’s not a guaranteed, fool-proof solution. Avoid using risk parity as a lone investment strategy and focus on diversifying and spreading risk in other ways.
About the Author
Natalie Redman is a freelance writer with two years of experience in web page copywriting for businesses across many industries. She’s also an owner of two blog websites and a Youtube content creator.