Risk parity

Risk parity is an asset allocation strategy that aims to equalize the risk contribution of each asset class to the total portfolio risk, rather than equalizing the capital allocation as in traditional 60/40 portfolios. The strategy was pioneered by Bridgewater Associates in the 1990s and has since become a dominant framework for institutional portfolio construction. Its core insight is that capital-weighted portfolios are typically dominated by equity risk: in a 60/40 stock/bond portfolio, equities contribute 80-90% of total portfolio volatility because stocks are far more volatile than bonds.

The risk parity approach uses leverage to equalize risk contributions. Because bonds have lower volatility than equities, a risk parity portfolio holds more bonds — often leveraged through derivatives or repo markets — to bring their risk contribution in line with equities. The result is a more diversified portfolio in risk space, though one that is inherently leveraged. The strategy performs well in most environments but is vulnerable to the volatility paradox: when volatility falls, risk parity funds must increase leverage to maintain their risk targets, creating a procyclical leverage cycle that amplifies market movements in both directions. The August 2015 "risk parity unwind" — when a volatility spike triggered simultaneous deleveraging across multiple funds — demonstrated that what appears to be diversification at the portfolio level can become concentration at the systemic level when many funds follow the same strategy.