TL;DR: Risk parity is a way of building a portfolio in which the risk contribution of each component (such as stocks, bonds and gold) is made roughly equal. Components with low price swings therefore get a larger weight. Professional providers often use leverage to raise total risk; for retail investors that brings extra risk and costs.
What can you expect?
- Time per week
- Little. After setup it takes a few hours per year for rebalancing and review.
- Starting capital
- You can start small with diversified funds or ETFs. Use only money you can do without for years. For products with a minimum investment, the provider's terms apply.
- Typical setbacks
- Years in which stocks and bonds fall together, lagging a simple stock portfolio, and estimates that prove wrong.
- Costs
- Fund costs (ongoing charges of ETFs), order fees, spread, possibly currency costs and tax (for Dutch individuals: wealth tax in box 3). Compare costs of brokers and products.
- Not suitable if…
- Not suitable if you need money in the short term, expect diversification to prevent every loss or want to use leverage without understanding the risks.
How it works
With risk parity you divide your risk, not your money. A regular 60/40 portfolio (60% stocks, 40% bonds) looks diversified, but most of the risk comes from the stocks. Risk parity gives volatile investments a smaller weight and calm investments a larger weight. Bridgewater Associates introduced its 'All Weather' approach in 1996, and the term risk parity came into use around 2005. It is a way of thinking, not a protected route to returns: in some years (such as 2022) stocks and bonds fell at the same time. This is not advice.
Core principles
- 1. Divide your risk across different kinds of investments, not just your money
- 2. Give investments with small price swings a larger weight and investments with large swings a smaller weight
- 3. Choose investments that behave differently in different conditions
- 4. Periodically bring the portfolio back to the chosen allocation (rebalancing)
Step-by- step plan
- 1
Set your goal and horizon
Write down what you are investing for, how long you can do without the money and how much of a fall you can bear. That sets your total risk.
- 2
Choose the categories
Choose a few categories that behave differently, for example stocks, bonds and gold, using diversified and low-cost products.
- 3
Estimate volatility per category
Use a fixed method to determine price volatility per category, for example over the last three years. Calculate the weights as in the worked example.
- 4
Buy and set rebalancing rules
Buy the products according to your weights. Decide in advance when to rebalance, for example yearly or at a fixed deviation.
- 5
Review and stay realistic
Look at your allocation and risk every year. Expect the portfolio to fall sharply in some years, even with a diversified approach.
In detail
The problem with 'diversified by money'
A 60/40 portfolio looks diversified, but bonds swing much less than stocks. As a result most of the price swings come from the stocks, even though they are only 60% of your money.
Risk parity asks the question differently: how much risk does each component contribute? The aim is that no single component dominates the result. Compared with a money-based split, that usually means more of the calm investments (such as bonds) and less of the volatile ones (such as stocks).
The approach is mathematically simple, but the outcome depends on estimates that change in practice.
Origin: All Weather and the term risk parity
Bridgewater Associates, Ray Dalio's firm, introduced the 'All Weather' approach in 1996, designed to perform reasonably in different economic conditions, such as growth, contraction, inflation and deflation. The term 'risk parity' came into use around 2005 via Edward Qian of PanAgora.
Popular books and articles often cite a simplified allocation (for example roughly 30% stocks, 55% bonds and the rest gold and commodities). That is an approximation; Bridgewater's actual strategy works with leverage and is not the same as such a simple retail allocation.
Correlation between investments
Diversification works when investments do not all move the same way at once. That relationship is called correlation and changes over time. In 2022 interest rates rose sharply, so stocks and bonds fell together. That shows the relationship from earlier years is not certain to hold.
Gold and commodities can behave differently in some situations, but they are volatile themselves and pay no interest or dividend. How you add them is a choice with pros and cons.
Leverage and practical choices
Because risk parity holds many calm investments, total risk is often low, and so is expected return. Professional funds therefore use leverage to raise risk. With leverage you borrow money, which costs money and can magnify losses. For most retail investors that is not a suitable choice.
In practice: choose diversified, low-cost products, set your rebalancing rules in advance, and account for transaction costs and tax (for Dutch individuals: box 3). A simple allocation you stick with is usually better than a complicated model you do not understand.
- Basic knowledge of stocks, bonds and diversification
- Long-term horizon
- Ability to accept temporary losses
- Broker with access to diversified index funds or ETFs
- Spreadsheet for weights and rebalancing
- Cost overview of products and broker
- 01 You decide the asset categories, for example stocks, bonds and gold, with a clear reason for each
- 02 You estimate volatility per category using a fixed method and fixed period
- 03 You calculate the weights and buy diversified, low-cost products (for example index funds or ETFs)
- 04 You set in advance when to rebalance, for example yearly or at a fixed percentage deviation
- 01 Your goal or time horizon changes, for example because you need the money sooner
- 02 You rebalance to the chosen weights, selling part of what has risen
- 03 A product becomes more expensive, less diversified or disappears, and you replace it
- 04 You adjust the method because your risk profile changes
Worked example
Hypothetical example (all figures are assumed). Two investments: stocks with a price volatility of 16% per year and bonds with 6%.
Step 1, inverse volatility: 1/16 = 0.0625 and 1/6 = 0.1667. Sum = 0.2292.
Step 2, weights:
- Stocks = 0.0625 / 0.2292 = 27.3%
- Bonds = 0.1667 / 0.2292 = 72.7%
With €10,000: stocks €2,727, bonds €7,273.
Step 3, check of risk contribution (simplified, ignoring correlation): weight x volatility.
- Stocks: 27.3% x 16 = 4.36
- Bonds: 72.7% x 6 = 4.36 (equal)
For comparison at 60/40: stocks 0.6 x 16 = 9.6 and bonds 0.4 x 6 = 2.4. Stocks then provide 80% of the risk (9.6 of 12.0).
Total volatility of the portfolio at an assumed correlation of 0.2: about 6.8% per year for the risk parity allocation, against about 10.4% for 60/40.
The risk parity allocation is therefore calmer. That usually also means a lower expected return. To match the risk of 60/40 you would need leverage, with extra cost and risk.
This is a calculation example with assumed figures, not advice and not an expectation.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- Stocks and bonds can fall together, as in 2022: diversification does not protect in every scenario
- The model uses estimates of volatility and correlation from the past, which can change
- Leverage (borrowing) magnifies losses and costs and usually does not suit retail investors
- Many bonds means sensitivity to rising interest rates; the portfolio can lag stock markets
- Use no leverage, or limit it strictly if you do consider it
- Keep costs low with diversified products and watch total yearly costs
- Rebalance by fixed rules and account for tax and transaction costs
- Choose a total risk that fits your horizon and that you can bear in a bad year
Learn the basics
Key takeaways
- Risk parity puts risk first, not money. A 60/40 portfolio draws most of its risk from stocks.
- Calm investments get a larger weight, volatile ones a smaller weight. Total risk is therefore usually lower, and so is expected return.
- No allocation works in every scenario. In 2022 both stocks and bonds fell.
- Leverage is not part of a simple retail approach and raises risk and costs.
Frequently asked questions
How do I set up a risk parity portfolio as a retail investor? +
By choosing a few diversified, low-cost funds or ETFs and calculating weights from their volatility, as in the worked example. Preferably use no leverage. Account for costs and tax, and choose a risk that fits your situation.
Does risk parity work when interest rates are high? +
That depends on the situation. When rates rise quickly, bonds lose value, and that happened in 2022 at the same time as stocks. A portfolio with many bonds can then lose a lot. No allocation is without risk in all conditions.
What return can I expect? +
That cannot be said. Expected return is usually lower than for a portfolio with more stocks, because risk is lower. Past returns say nothing certain about the future. You can also lose money.
Origin
Devised by / based on: Bridgewater Associates (Ray Dalio) . Source: All Weather strategy (Bridgewater, 1996); the term 'risk parity' dates from 2005 (Edward Qian, PanAgora)