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Understanding Risk Parity - AQR
Understanding Risk Parity
So, You Think You’re Diversified...
The outperformance of Risk Parity strategies during the recent credit crisis has provided
evidence of the benefits of a truly diversified portfolio. Traditional diversification focuses
on dollar allocation; but because equities have disproportionate risk, a traditional
portfolio’s overall risk is often dominated by its equity portion. Risk Parity diversification
focuses on risk allocation. We find that by making significant investments in non-equity
asset classes, investors can achieve true diversification – and expect more consistent
performance across the spectrum of potential economic environments.
First, the paper highlights the concentration risk embedded in traditional portfolios,
and explains the intuition behind Risk Parity. Next, we describe a Simple Risk Parity
Strategy and demonstrate its consistent outperformance over nearly 40 years of
historical data. Finally, we delve into the more advanced portfolio construction and
risk management techniques used to implement actual Risk Parity portfolios.
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