"Risk Parity Portfolios: Efficient Portfolios Through True Diversification"
Accessible, short paper that explains the basic theory behind risk parity portfolios: allocation of risk equally across asset classes. First published use of the term “risk parity,” and great for understanding why true diversification is important.
Read the original:
Important Points for the RP Investor:
Page 1: Begins with common “don’t put all your eggs in one basket” maxim, but then investigates how the classic 60/40 does just that. Qian (pronounced more or less like "Chen") writes that the “size” of the eggs is important, not just the quantity, and in terms of risk, the “stock eggs” are much more volatile than the “bond eggs.” Stocks thus dominate the portfolio from a risk perspective, even if it seems somewhat balanced in terms of allocation. Qian writes that in a 60/40, stocks contribute about 93% of the risk, bonds just 7%, meaning that while a 60/40 “might appear balanced in terms of capital allocation, it is highly concentrated from the perspective of risk allocation.”
Page 2: In a 60/40, stocks will typically account for the vast majority of losses, and thus the bonds are insignificant for diversification. How then, Qian asks, can we design “a portfolio that limits the impact of large losses from individual components?” The answer is to make sure that the expected loss contribution is the same for all components, or put simply, to portfolios based on risk parity.
Page 2: Table 2 shows return and variance expectations for five portfolios: an all stock, an all bond, a 60/40, an un-leveraged risk parity portfolio (just called "parity"), and then a leveraged risk parity portfolio.
The take home point here is that the two RP portfolios both have better risk-adjusted returns, either on the safe side (unleveraged) or the riskier side (leveraged).
Page 3: Great discussion about the use of leverage to target various risk/return levels. Keep in mind that a risk parity portfolio allows you to do two basic things: either target the same level of return with lower risk, or maintain the same level of risk to achieve higher returns. Leverage is not necessary in the first case (just greater allocations to uncorrelated asset classes) but is in the second case. The result is shown on Table 4, in which Qian shows how leveraged can be used to mimic the risk of an all stock portfolio or of a 60/40 portfolio:
Page 4: Qian anticipates a common critique of the use of leverage in RP portfolios by noting that investing in stocks with inherited leverage is already commonplace, and shouldn’t be considered that odd for investments in other asset classes. Given that the paper was written in 2005, leverage means the use of futures contracts, though in 2021, individual investors can use leveraged ETFs like UPRO or TMF, instead.
Edward Qian is the Chief Investment Officer for the Multi Asset Group at PanAgora Asset Management. Here is his biography page, and a list of his papers. Qian collected and adapted some of his papers in book form as "Risk Parity Fundamentals." Here is my summary of it.
Also, here is the book itself: