What Is Risk Parity? How Equal-Risk Portfolios Work, and the Year They Broke

Risk parity builds a portfolio where every asset contributes the same amount of risk. Stocks are volatile, so they get a small weight. Bonds are calm, so they get a large one, and the manager usually borrows to bring the return back up.

Balance the risk, not the dollars. Everything else in the strategy follows from that one rule.

I build risk-managed models for advisers, so I spend a lot of time inside the math of how much risk each position carries. What follows is how risk parity actually works, with numbers: why a 60/40 portfolio is mostly a stock portfolio, how the equal-risk weights get set, where the leverage comes from, and what happened in 2022, when the assumption underneath the whole design stopped holding. Along the way, three practitioners from Behind the Ticker explain how they handle the same problem in their own work.

What is risk parity, in plain terms?

A 60/40 portfolio splits the money. Sixty cents of every dollar goes to stocks and forty to bonds. Split the risk instead and the picture looks nothing alike.

Risk here means volatility, the size of a portfolio’s typical swings. Each holding contributes some share of the portfolio’s total volatility, and that share depends on two things: how big the position is, and how much the asset moves.

Risk parity sets the weights so every asset’s share of the risk is equal. With two assets, each carries half. With four, each carries a quarter.

The idea has two parents. Ray Dalio ran the logic at Bridgewater Associates from 1996 inside the All Weather fund. Edward Qian at PanAgora gave it the name "risk parity" in a 2005 paper. Daniel Snover, founder of PMV Capital, made the lineage plain on Behind the Ticker: risk parity is "really an offshoot of the all weather strategy", and the two terms point at the same idea.

Why is a 60/40 portfolio mostly a stock portfolio?

Take round numbers that sit near the long-run averages. US stocks at 15 percent annualized volatility. High-quality bonds at 5 percent. Assume, for now, that the two do not move together.

The arithmetic is short. A position’s contribution to variance is its weight squared times its volatility squared. For stocks that is 0.36 times 225, or 81. For bonds it is 0.16 times 25, or 4. Stocks carry 81 of the 85 units of risk, which is 95 percent.

So forty percent of the money is doing about five percent of the risk work.

Snover put the same point in practitioner’s terms. With stocks four or five times riskier than bonds, he said, "stocks are accounting for more than 90% of the risk of that 60, 40 portfolio", and the correlation of a 60/40 portfolio to the S&P 500 runs around 0.95. A portfolio that moves 95 percent in step with the stock market is getting very little diversification from its bonds.

His description of the goal is the cleanest one I have heard. Risk parity tries to capture the return of each asset class and "combine those assets in a way to where the systematic risk of each one of them offsets".

How does risk parity set the weights?

The simplest version weights each asset inversely to its volatility. An asset with one third the volatility gets three times the weight.

Each side now carries half the risk, which is the equal-risk portfolio in its simplest form.

Every risk parity process runs some version of these five steps:

1. Measure the volatility of each asset. Managers use a trailing window, commonly somewhere between 60 days and three years. 2. Weight inversely to that volatility. Half the risk gets twice the weight. 3. Adjust for correlation. Two assets that move together are one source of risk, so the weights account for how each pair moves. 4. Scale the whole portfolio to a volatility target. Usually with leverage. The next section covers why. 5. Rebalance on a schedule. Monthly or quarterly, whatever the last quarter did.

Most funds use more than two assets. A typical mix adds commodities, inflation-linked bonds, and sometimes gold, each sized by its own volatility.

Why does risk parity use leverage?

Look at the portfolio volatility in that second table. About 5.3 percent a year, against about 9.2 for the 60/40.

Lower risk comes with lower expected return. A portfolio that is three quarters bonds behaves like a bond fund with some stock attached.

So the manager borrows. Lever the equal-risk portfolio about 1.75 times and its volatility climbs back near 9 percent.

The extra 75 percent is financed, usually through futures or the repo market. Most of it lands on the bond side, because that is where most of the weight already sits.

Advisers should be clear on this step. The borrowing is how the strategy reaches a usable return, and the size of it decides how the portfolio behaves in a losing year for bonds.

How have practitioners applied the equal-risk idea?

Risk budgeting shows up well outside funds that carry the risk parity label.

Jerry Prior of Mount Lucas Management described how his firm’s managed futures index set its sector weights in 2005. The index "gave 42 and a half percent to bonds, 32 and a half percent to currencies and 25% to commodities". Bonds got the most because they are the least volatile, commodities the least because they are the most volatile, so that each sector would carry an equal contribution to risk through market cycles.

Bond volatility later fell to very low levels, and a strict volatility rule would have answered by pushing bond exposure up even further. The index committee reviews the weights every year and left them where they were. As Prior put it, "we value being roughly right on these weights instead of precisely wrong".

That choice matters for the 2022 story below. A rule that scales exposure to recent volatility carries its largest bond weight at exactly the moment bond volatility is lowest.

Snover’s firm runs a different variant. Rather than balancing risk across all environments at once, his process first screens for asset classes that are trending upward over several lookback windows between three and twelve months, then balances risk among those. He described it as building "risk parity portfolios over each of those periods" and blending them together.

What happened to risk parity in 2022?

The design rests on one assumption. When stocks fall, bonds rise, or at least hold up. That is what lets a portfolio carry 131 percent in bonds without the bonds and the stocks hurting it at the same time.

The data supported that assumption for a long stretch. Using monthly returns of the S&P 500 and intermediate Treasuries, the trailing 24-month correlation between the two sat below zero at almost every year-end from 2005 through 2021. It reached negative 0.73 at the end of 2011 and was negative 0.37 at the end of 2021.

Then inflation returned. The Federal Reserve raised rates seven times in 2022, moving its target from a range of 0 to 0.25 percent to a range of 4.25 to 4.50 percent. Bonds fell because rates rose. Stocks fell because rates rose. By year-end the same 24-month correlation was positive 0.54, and it stayed positive through 2024.

Here is the levered portfolio from the table above, run through 2022, using the S&P 500 for stocks and the Bloomberg US Aggregate for bonds.

The hypothetical equal-risk portfolio lost more than the 60/40 it was built to improve on. The bond sleeve did most of the damage, because that is where the leverage sat.

Financing made it worse. Borrowing near zero is cheap. Borrowing at four percent is not, and the cost of the leverage rose all year while the assets it funded were falling.

None of this requires a manager error. The rule did what it was written to do, in a regime it was not designed for.

What is the problem with volatility targeting?

Most risk parity funds hold the portfolio near a volatility target, and that target adds a second behavior advisers should understand.

Yang Tang, co-founder of Arch Indices, explained why his firm’s indexes avoid it. When markets are calm, hitting a target means levering up. When volatility spikes, it means cutting exposure. In his words, "because volatility went up, you would have to reduce exposure, which actually leads to adverse outcomes for investors", and levering up when volatility is low "will give you adverse outcomes if volatility spikes". His indexes use no leverage at all.

Put Tang’s point next to Prior’s and the 2022 mechanism is clear. Bond volatility was low in 2020 and 2021, so a volatility-scaled portfolio held large bond positions going into the year. When rates moved, volatility jumped, and the rule then cut exposure after much of the loss had already happened.

What is hierarchical risk parity?

Classic risk parity needs a covariance matrix, the table of how every asset moves against every other. With 20 assets that matrix holds 190 separate correlation estimates, and every one of them carries estimation error.

Marcos Lopez de Prado published an alternative in 2016. Hierarchical risk parity groups assets into clusters by how similarly they behave, then allocates risk down the resulting tree. It never inverts the covariance matrix, which removes the instability that makes classic risk parity weights jump on small changes in the data.

The tradeoff is that the clustering is itself a choice. Change how similarity is measured and the portfolio changes with it.

Which funds use risk parity?

AQR launched a risk parity mutual fund in 2010. The first ETF built around the approach listed in December 2019, and a small number of others have followed, including adaptive versions like Snover’s that change the asset mix with market trends.

Two numbers decide what any of them actually is. The volatility target, and the leverage cap. A fund targeting 10 percent volatility with leverage up to three times is a very different holding from an unlevered fund with the same label.

How should an adviser evaluate a risk parity fund?

Read three things in the prospectus before the marketing deck.

1. The volatility target. It sets how much total risk the fund takes and how often it rescales. 2. The leverage cap. It sets how far the fund can borrow when markets are calm. 3. The duration of the bond sleeve. Duration decides how hard a rate shock lands on the largest position in the book.

Then ask the manager one question: how did the weights move through 2022, month by month? The answer tells you whether the process cut exposure before the damage or after it.

Where the fund sits in a model matters too. Snover’s own suggestion to advisers is to "leave their stock allocation where it is" and use the strategy in place of part of the core bond allocation, which he argued was a weak diversifier to stocks in recent markets.

Risk parity sizes positions by volatility and holds them through whatever arrives. An adaptive approach asks a different question, about whether to hold the risk asset at all when price trends turn down. THOR reads price and seeks to reduce drawdowns by moving toward cash. Our piece on adaptive versus strategic asset allocation covers how that decision gets made, and managed futures ETFs show a third route to the same goal.

Definitions

Risk parity. A construction rule where every asset contributes an equal share of the portfolio’s total risk.

Risk contribution. The share of portfolio volatility that comes from one holding.

Volatility targeting. Scaling total exposure up or down to hold portfolio volatility near a fixed number.

Gross exposure. Long plus short positions as a percentage of capital. Levered risk parity portfolios usually run well above 100 percent.

Stock-bond correlation. How closely stock and bond returns move together. Risk parity depends on it staying low or negative.

Hierarchical risk parity. A 2016 variant that clusters assets by similarity instead of inverting a covariance matrix.

All Weather. Bridgewater’s 1996 fund, the first large application of the equal-risk idea.

Educational content only. This is not investment advice and not a recommendation regarding any security. Index figures are cited as historical illustration; the 60/40, equal-risk and levered portfolios are hypothetical and exclude fees and financing costs. Correlation figures are computed from monthly returns of ETFs tracking the S&P 500 and intermediate US Treasuries. Fund managers quoted are speaking about their own approaches on Behind the Ticker. Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.