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INVESTMENT FUNDAMENTALS What is risk parity? © 2023 SEI 1 Investors are typically counseled to diversify capital across asset classes to reduce risk. Considering this, it may be a surprise to learn how concentrated the risk sources of a traditionally diversified portfolio may be. Risk parity is an investment strategy that seeks to balance the sources of risk in a portfolio. The easiest way to envision this concept may be to consider it in the context of a traditional, diversified portfolio. For many investors, this portfolio is represented by defined percentage allocations across stocks and bonds. Such a balanced portfolio, for example, may allocate 50% of its assets to stocks and 50% to bonds in an effort to achieve diversification. However, the theory of risk parity indicates that this equal allocation of investment capital does not necessarily equate to being diversified by risk. This is because stocks tend to exhibit four-to-five times more volatility than bonds. So, while the weighting of a balanced portfolio appears to be adequately diversified, the investment in equities carries significantly greater risk than the investment in bonds. Exhibit 1 highlights the disparity. Exhibit 1: Balanced portfolio allocations For illustrative purposes only. Risk parity: balanced risk Risk parity investment strategies seek to diversify sources of risk. Each source of risk carries a risk premium, which is a potential source of return. To achieve this diversification, these strategies assume that asset classes (such as stocks and bonds) should contribute equally to the level of risk in a portfolio. As shown in Exhibit 2, given the different historical volatility of stocks and bonds, to achieve a balanced risk contribution between the two assets classes, the allocation to bonds must be much larger than that of stocks. 50% 50% Capital allocation 5% 95% Risk allocation Bonds Stocks