Risk Parity and Diversification

Abstract

Traditional 60/40 asset allocation portfolios are not truly diversified because they have an unbalanced risk allocation to high-risk assets. As a result, their expected risk-adjusted returns are low. Risk parity is a new way to construct asset allocation portfolios based on the principle of risk diversification, achieving both higher risk-adjusted returns and higher total returns than traditional asset allocation approaches. The diversification benefits of risk parity portfolios also include balanced correlations to underlying asset classes and stronger downside protection against severe losses. Risk parity portfolios can also incorporate active views on risk-adjusted returns of different asset classes. All of these features make risk parity an attractive alternative to traditional asset allocation approaches.