A beginner's guide to risk parity

A common portfolio holds 60 percent shares and 40 percent bonds. It sounds balanced, but most of its risk comes from shares. Risk parity tries to fix this. This page explains what risk parity means, how it works and what its weak points are.

Quick answer

Risk parity is a way to build a portfolio so that each asset class contributes about the same amount of risk, instead of getting the same amount of money. Since bonds usually move less than shares, a risk parity portfolio holds more bonds and fewer shares by money value. Some large funds also use borrowing to raise expected returns of the lower-risk part.

Key takeaways

• It balances risk, not money, across assets.
• Risk is usually measured by volatility.
• Lower-risk assets like bonds get bigger weights.
• Bridgewater's All Weather approach helped make it popular.
• It can suffer when shares and bonds fall together.

What is risk parity?

Most portfolios are built by deciding how much money to put in each asset. Risk parity starts from a different question: how much risk does each asset add? The aim is to make those risk contributions roughly equal.

Risk is usually measured by volatility, which shows how much an asset's price swings. Shares tend to swing far more than high-quality bonds, so an equal money split leaves shares driving most of the portfolio's ups and downs.

A simple example

Take a portfolio with 60 percent in shares and 40 percent in bonds. Because shares are much more volatile, studies often find that shares account for around 90 percent of this portfolio's total risk. The bonds hardly matter for the swings.

A risk parity version would cut the share weight and raise the bond weight until each part adds a similar amount of risk. The exact split depends on how volatile each asset is and how they move together.

Where did risk parity come from?

Bridgewater Associates launched its All Weather approach in 1996, built on balancing risk across assets that do well in different economic conditions. The term itself was used by Edward Qian of PanAgora in a 2005 paper.

Many institutional investors later adopted versions of the idea. Some use leverage on the bond portion so that the overall portfolio can aim for returns similar to a share-heavy mix, with risk spread more evenly.

What are the limits?

Risk parity relies on past volatility and correlations, which can change quickly. When interest rates rise sharply, shares and bonds can fall at the same time, as happened in 2022 in many markets. This can hurt a bond-heavy portfolio.

Using borrowed money adds its own risks, such as higher costs and forced selling in stressed markets. Past performance is not indicative of future results.

What can an ordinary investor learn from it?

You do not need a complex fund to use the main lesson. When you plan your asset allocation, look at how much each part can swing, not just how much money it holds. A portfolio that looks balanced by money may not be balanced by risk.

In short, the method is about spreading risk evenly. It is a useful way to think about diversification, even for people who do not use the full method.

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