The Modern Portfolio Theory and Risk Parity
Risk parity is one way to allocate your portfolio where you use risk to determine allocation through the investment portfolio’s many components. This strategy is similar to the Modern Portfolio theory. It is like a modified approach involving investments using leverage. Before anything else, let us start with MPT or Modern Portfolio theory.
The aim is to make an investment portfolio with diverse and specified assets to optimize returns while meeting the market risk parameters. This is possible by looking at the risks and returns for the whole portfolio. However, this is only by utilizing positions that are long and without margin. So, how does this relate to risk parity? Portfolio managers use the risk parity strategies to end up with exact capital contribution proportions of the portfolio’s asset classes to have maximum diversification for different goals and investor preferences.
What is a risk parity?
Risk parity is a more advanced portfolio technique. We say this because the users are often hedge funds and sophisticated investors. Also, its quantitative methodology is not simple. It is so complex that its allocations are more advanced than the simplified ones. It aims to generate optimal returns at the targeted risk level.
What is a simplified allocation strategy? For example, we have a portfolio with 60% stocks over 40% bonds. They use MPT as it gives a standard for providing diversification within an investment portfolio. It maximizes the expected return for every risk level. The Simplified MPT strategies use stocks and bonds. In the allocation, the investor’s equities are heavier than the bonds for those more willing to take more risks. On the other hand, the risk-averse will prefer capital preservation, so they put heavier weights on bonds.
The risk parity strategy makes leverage and alternative diversification with short selling in portfolios and funds possible. Portfolio managers are free to mix any asset they prefer. It uses an optimal risk target level as a basis for investing instead of making allocations to different asset classes. This can happen by using leverage to weight risk equally to various classes with the help of the optimal risk target level.
What are the methods?
It is common to have stocks and bonds in the investment portfolio when using the risk parity strategy. It discerns the investment class proportions using the targeted risk and return levels instead of a predetermined proportion of asset diversification. We explained one earlier, which is the 60/40 stock-bond portfolio. MPT was the start. From there, there was massive improvement and changes. Investors can target certain risk levels and divide those risks across the investment portfolio. This helps in achieving optimized portfolio diversification.
What is a security market line?
The risk parity approach will never be complete without the security market line or SML. It shows the relationship between the risk and return of assets using a graphical representation. One can use this in CAPM or capital asset pricing model. The market’s beta determines the slope of the line. The line most likely slopes upward. The higher the possibility of asset returns, the higher the risk.
Risk parity saves the day.
It seems like there is an automatic assumption that the SML slope is constant. However, it is not always the case. Investors in a 60/40 stock-bond allocation take more significant risks to get more returns. The diversification benefits are lesser and riskier because the equities are heavier than the bonds. Here is where risk parity comes into the picture. It solves the problem by using leverage to balance the volatility amount and risk throughout the portfolio’s asset types and classes.