A portfolio construction approach that allocates capital based on risk contribution rather than capital weight — ensuring each asset class contributes equally to total portfolio volatility.
“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist.”
— Ray Dalio
Deeper Explanation
Risk parity is the portfolio construction principle underlying Bridgewater's All-Weather strategy. It begins with the observation that the traditional 60/40 equity-bond portfolio, despite appearing diversified across two asset classes, is actually approximately 90% equity risk — because equities are three to four times more volatile than bonds. When equities decline sharply (as they do in recessions and market crises), the bonds in the portfolio do not sufficiently offset the equity drawdown. Risk parity addresses this by allocating capital based on the risk each asset class contributes to total portfolio volatility, rather than by nominal dollar weight. Since bonds are less volatile than equities, achieving equal risk contribution requires holding substantially more bonds than equities on a capital basis. To generate equity-comparable expected returns from a bond-heavy allocation, risk parity strategies typically use modest leverage on the bond position. The practical result is a portfolio where each major asset class — equities, bonds, commodities, inflation-linked bonds — contributes roughly 25% of total portfolio risk. When any single asset class experiences a severe drawdown, the portfolio loss is limited to approximately that 25% contribution rather than the 90% contribution that equities make to the traditional 60/40 portfolio. Risk parity's critics note that the approach has historically relied on bonds providing negative correlation to equities (when equities fall, bonds tend to rise). This relationship held reliably from the mid-1990s through the early 2020s, when interest rates were generally falling or low. In periods of rising interest rates and inflation — when both equities and bonds may fall simultaneously — the diversification benefit of risk parity is reduced. The 2022 market environment, when both global equities and bonds fell sharply due to rapid rate increases, tested this assumption significantly. Despite these limitations, the risk-parity principle — that portfolio construction should balance risk exposures, not just capital allocations — remains one of the most important insights in modern portfolio management.
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