Investing in financial markets involves a lot of planning because there is a plethora of securities, markets and economies that can be traded. Some traders prefer short-term gains provided by volatile securities, while others prefer holding onto security for weeks and months.
However, portfolio diversification is one way to combine different types of assets that focus on the overall portfolio growth, entailing investing in several markets at the same time.
Therefore, putting all your money in one asset may lead to excessive losses if that particular asset moves unexpectedly or becomes subject to unprecedented external forces.
There are several ways to diversify your portfolio and keep your “eggs in different baskets”, and risk parity is one of those methods. Let’s discuss this strategy and how to use it with a few examples.
What is Risk Parity?
How do you diversify your trades, and what type of investments shall you seek? This strategy assists you in allocating asset classes in a way that controls associated risks, not to expose your portfolio.
Risk parity is a portfolio management strategy, entailing what assets you must invest in and by what proportions.
This strategy relies on risk diversification, giving each security a weighted risk value and ensuring that your investments have more expected returns than risks.
Risk parity strategy is built on two major concepts: the returns of low-risk assets must offset the returns of high-risk assets, and the gains while using a margin trading account must be higher than your gains using a regular trading account.
Therefore, you ensure that your portfolio does not involve exaggerated risks that put your capital at risk and that any risk you take brings higher returns.
Asset Allocation Using Risk Parity Strategy
Risk parity involves investing in low-risk and low-volatility securities. If you add any high-risk assets to your portfolio, they must bring higher returns than others. This is how you can build your investment portfolio using this strategy.
- Security type: a trader must invest in long-term securities characterised by low volatility, like blue-chip stocks, US bonds, and other stable commodities. Investing in hedge funds and real estate is also part of this strategy. Each security is valued by the risk contributing to the overall portfolio risk.
- Risk level: this strategy measures the asset’s risk by possible market losses and economic factors, like inflation and interest rates.
- Geographical diversification: securities must be sourced from different asset classes, markets, and countries. This way, one economic crisis does not damage the whole portfolio and may be offset by the gain of another national economy.
The risk parity strategy considers different risk tolerances between traders, whereas a risk-taking trader can incorporate high-risk, and their risk allocation differs from risk-averse investors.
However, in both scenarios, investing in diversified securities from different countries and markets is essential.
One way to build your portfolio is using all-weather allocation, which entails investing in securities not affected by inflation, rate of return and economic growth.
This way, 70% of your investment involves US stock and long-term bonds, while medium-term bonds, commodities, and gold make up the other 30%.
Another way to build your risk parity portfolio is to include long-term and stable securities besides short-term and volatile ones. This approach divides your portfolio evenly between US stocks, gold and long-term and short-term treasury bonds.
Both approaches consider gold, equities and treasury bonds one of the safest investment options, ensuring steady income streams with minimum fluctuation.
Conclusion
The risk parity strategy looks at tradable securities from a risk tolerance point of view, giving each asset a value based on the associated risks, like losing market position and inflation factors.
Therefore, risk parity asset allocation involves stable products like gold, treasury bonds, US stocks and ETFs, besides long-term investments like long-term US treasury bonds.
This way, coupled with geographical diversification, a trader safeguards their portfolio from sudden market movements or economic shocks.
