Two Paths of RP

RP approaches are diverse, but at a basic level, follow one of two paths. They are not necessarily risky nor safe, but do provide a framework to balance assets at different degrees of total risk.

Risk Parity portfolios are created by:

  1. Employing true diversification without using leverage to pursue equivalent returns to a conservative portfolio like the 60/40, but with lower volatility. In short, these relatively conservative  RP portfolios target the same returns of traditional portfolios, but with lower expected risk
  2. Employing true diversification and strategically using leverage to pursue higher returns with a similar volatility portfolio as a more aggressive equities-based portfolio, like an 80/20 or even 100% equities. In short, these relatively aggressive RP portfolios target the same risk levels of traditional portfolios, but with higher expected returns.

In the original formulation, professional investors used leverage (meaning: using borrowing to finance larger positions in some assets) to raise total returns for the portfolio. Indeed, in the world of professional investment managers, RP is often seen as synonymous with the use of leverage. For this very reason, RP has at times been discarded straight-away by individual investors who are hesitant or unable to use leverage. Elsewhere in this blog, I’ll argue that leverage is often misunderstood and I’ll even make the case that leveraged certain assets within a portfolio can actually make the entire portfolio less risky than it would be otherwise. For the time being, though, individual investors who feel that leverage is outside of their comfort zone, should know that RP does not have to include leverage at all.

The larger point is that RP is neither an inherently safe strategy, not an inherently risky one. Rather, it is fundamentally a way to create balance in a portfolio, and investors can then level up their risk (with leverage) or dial it back (without).

As Thomas Lee notes:

It is worth noting that a risk parity strategy can target any level of portfolio risk and thus excess return. Theoretically, an investor with a long horizon would prefer to target a higher level of risk, while an investor with a shorter time horizon would be inclined to seek a lower level of risk. Both investors could hold the same asset classes and thus own similarly diverse portfolios. The only difference between the portfolios would be the notional exposure to achieve the investor's target risk level.