Risk Parity

Risk Parity is an allocation rule in which each asset contributes the same amount to total portfolio risk — typically volatility, sometimes CVaR. It was popularised by Bridgewater's All Weather fund and rests on a simple intuition: equal risk contribution diversifies risk, not capital. A 60/40 portfolio is "risk parity" only in dollar terms — almost all the risk comes from the equity sleeve. True risk parity overweights bonds and may add leverage to reach the equity-portfolio volatility target.

Formula (equal-risk-contribution)

For weights w and covariance matrix Σ, the risk contribution of asset i is:

RC_i = w_i · (Σw)_i / sqrt( w' · Σ · w )

Risk Parity solves for w such that RC_i = RC_j for all i, j. There is no closed form; the solver iterates. A common simplification is "inverse-volatility" weighting (w_i ∝ 1/σ_i) which is equivalent under zero correlation but biased when correlations are non-zero.

Leverage matters

Risk Parity without leverage is conservative — total volatility is typically far below an equity benchmark. Most institutional Risk Parity products lever the portfolio (typically 1.3-1.5x) to reach a target volatility of 8-10%. Without that step, the comparison against 60/40 happens at different risk levels and the Sharpe advantage disappears.

When Risk Parity breaks

The implicit assumption is that bonds hedge equity — a negative SPY/TLT correlation. In 2022 that correlation turned positive for the first time in two decades and Risk Parity drew down 18% in nine months, worse than the 60/40. Risk Parity is an implicit bet on negative bond-equity correlation; it should be disclosed when one positions oneself as "regime-neutral".

How MEDGE Capital uses Risk Parity

Risk Parity is one of the 12 optimization objectives (with target leverage set by the user) and a preset portfolio (vol-target ≈ 9.5%). The dedicated blog post "Risk Parity vs 60/40: an honest benchmark" backtests both across 10-, 20- and 30-year windows.