The Dangers of Risk Parity

Abstract

Risk parity is a portfolio construction methodology that is extremely attractive if standard deviation is a good estimate of the risk of asset classes and if there is a wide variety of asset classes that are likely to offer fairly uncorrelated risk premia. In reality, however, standard deviation is a dangerously limited estimate of the true risk of an asset class and there may well be very few risk premia that are truly available to be exploited. Adding to the problem is the fact that bond yields today are at generational lows and sovereign debt loads are at extremely high levels, making the risk of significantly negative bond returns or even sovereign default much higher than history would suggest. The traditional 65/35 portfolio, while far from ideal, at least seems overwhelmingly likely to offer a decent premium over cash in the long run and should be able to survive either economic depression or sovereign default.