Risk Parity Defined

What is Risk Parity, anyway? A brief primer on the concept, including goals, important elements, and what makes it unique.

Risk Parity (RP) is an approach to asset allocation in investing that emphasizes balancing risks between asset classes. Its goal is to create diversified portfolios that can achieve steady returns in a variety of economic environments.

While insights from an RP approach can be used in different ways by different investors with different objectives, RP is perhaps best suited for the investor in the decumulation phase of investing: when the money from investments is needed for living expenses, and little, if any, money is being added to the portfolio.

The RP approach to asset allocation (put simply: how much of your portfolio you have in which type of asset) stresses understanding the correlation between types of assets, that is, how the returns are similar, opposite, or unconnected to each other. It seeks to combine assets in such a way that, during any particular economic environment (growth, decline, high inflation, low inflation), there is some asset doing well. By definition, this also means that RP portfolios will typically contain asset classes that are out of favor, as well.

It is through the combination of asset classes with different risk profiles and different patterns of growth and decline that RP portfolios have achieved steadier and more dependable returns than many traditional portfolios, as backtests have shown. Of course, past returns do not guarantee future results.

While Risk Parity can be pursued actively and is most prominent at the scale of large investment management companies, here we focus on RP as a type of passive investing based on common, broad-based, index ETFs available to the everyday investor.