Risk Parity

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Definition of 'Risk Parity'

Risk parity is a portfolio construction approach that seeks to balance risk across asset classes by allocating assets in proportion to their risk contributions. This is in contrast to traditional portfolio construction approaches, which typically allocate assets in proportion to their expected returns.

The goal of risk parity is to achieve a portfolio with a target level of risk, while minimizing the volatility of the portfolio's returns. This can be achieved by using a variety of asset classes, including stocks, bonds, commodities, and real estate.

Risk parity portfolios are often used by institutional investors, such as pension funds and endowments, because they can help to reduce the risk of their portfolios while still maintaining a target level of return.

There are a number of advantages to using risk parity. First, risk parity portfolios can help to reduce the volatility of returns. This can be beneficial for investors who are concerned about the risk of their portfolios. Second, risk parity portfolios can help to improve the risk-adjusted returns of portfolios. This means that risk parity portfolios can generate higher returns for a given level of risk.

However, there are also some disadvantages to using risk parity. First, risk parity portfolios can be more complex to manage than traditional portfolios. This is because risk parity portfolios require the use of a variety of asset classes, and the allocation of assets in these portfolios must be regularly adjusted to reflect changes in the risk of the underlying assets. Second, risk parity portfolios can be more expensive to manage than traditional portfolios. This is because risk parity portfolios often require the use of active management, which can be more expensive than passive management.

Overall, risk parity is a portfolio construction approach that can be used to achieve a number of investment goals. However, it is important to understand the advantages and disadvantages of risk parity before using it in a portfolio.

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