11 Asset allocation by risk: Introduction to risk parity
This chapter covers
- Understanding risk contributions in investment portfolios
- Using different definitions of risk-parity portfolios and computing their weights
In chapter 10, we saw two pitfalls of mean-variance optimization:
- Without explicit constraints on diversification, mean-variance optimization can result in very concentrated portfolios.
- The weights of portfolios obtained using mean-variance optimization can be very sensitive to the inputs: expected returns, covariances, and constraints.
We’ll start this chapter by revealing another unattractive property of portfolios that appear to be diversified and how this motivates us to allocate assets within a portfolio by risk rather than by capital—an approach known as risk parity. We’ll cover several different risk-parity methods for constructing portfolios according to each approach and also discuss some practical implications of managing a risk-parity portfolio.