Risk Parity

Risk parity answers a question mean-variance optimization dodges: what if you allocated risk equally instead of allocating capital equally? In a conventional 60/40 portfolio the equity sleeve holds 60% of the money and roughly 90% of the volatility, so calling it balanced is a fiction of accounting. Risk parity sizes each asset so that its contribution to total portfolio variance is equal — which, because bonds are perhaps a third as volatile as equities, means holding far more bonds than stocks by dollar weight.

That construction has a consequence people skip past. A portfolio balanced on risk has a lower expected return than one balanced on capital, because you have crowded into the low-volatility, low-return assets. Risk parity in its institutional form fixes this by borrowing: lever the whole balanced portfolio until its total risk matches the 60/40 you were going to hold anyway, and you keep the superior risk balance while restoring the return. The theoretical warrant is the observation that the empirical security market line is too flat — low-beta assets have historically delivered better risk-adjusted returns than high-beta ones, so the investor willing and able to lever the low-beta asset captures the difference.⁹⁰

Leverage is therefore not an optional addition to risk parity. It is the mechanism. Three implications follow for anyone tempted by a retail version:

Unlevered risk parity is just a bond-heavy portfolio

It has the lower return without the compensating structure, which is exactly what the 2022 drawdown of the popular retail allocation demonstrated (section “The “All Weather” and “All Seasons” Portfolios”).

Financing cost decides whether it works

The strategy earns the spread between low-beta returns and your borrowing rate. Institutions borrow at or near the repo rate through futures and swaps; a retail investor paying broker margin rates gives the entire edge back. If you intend to lever, do it through the embedded financing in futures (section “Fixed-Income Futures”) or a box spread (section “Box Spread”), not a margin loan.

Leverage converts a drawdown into a forced sale

The unlevered investor waits out a bad year; the levered one meets a margin call at the bottom. Size to survive the correlation breakdown described in section “MPT Under Deep Uncertainty”, not to the volatility estimated in calm markets.

The honest summary: risk parity is a genuine insight about how portfolios are actually balanced, implemented through a mechanism most individual investors cannot access on institutional terms. Take the insight — stop confusing dollar weights with risk weights — and be skeptical of the packaged product.