11 Asset Allocation by Risk: Introduction to Risk Parity
This chapter covers
- The concept of risk contributions in investment portfolios
- Different definitions of risk parity portfolios, and means of computing their weights
In the last chapter, we saw two pitfalls of mean-variance optimization:
- Without explicit constraints on diversification, mean-variance optimization could 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 allocating assets within a portfolio by risk, rather than by capital - an approach known as risk parity. We’ll cover several different forms of risk parity methods for constructing portfolios according to each approach, and also discuss some of the practical implications of managing a risk parity portfolio.