Risk budgeting and risk parity

A traditional portfolio is described by how its money is split. A more revealing question is how its risk is split — and that is rarely the same thing.

The hidden concentration of 60/40

In a 60/40 stock/bond portfolio, the money looks balanced. But stocks are far more volatile than bonds, so once you measure where the risk comes from, equities often account for 85 to 90 percent of the portfolio's total risk. The portfolio is far less diversified than it appears — it is essentially an equity bet with a bond cushion.

Risk budgeting: allocate risk, not dollars

Risk budgeting flips the design question. Instead of deciding what fraction of money each asset gets, you decide what fraction of risk each is allowed to contribute, then back out the dollar weights that achieve it.

Traditional view: "stocks get 60 percent of the money"
Risk-budget view: "stocks may contribute 50 percent of the risk"

Risk parity: equalize the contributions

Risk parity is the special case where every asset contributes the same amount of risk. To equalize contributions, you hold more of the low-volatility assets (bonds) and less of the high-volatility ones (stocks). A risk-parity portfolio might be 30 percent stocks and 70 percent bonds by money, yet balanced by risk.

The leverage twist

Risk parity portfolios are lower-risk and therefore lower-return in raw form, so practitioners often lever them up to reach an equity-like expected return while keeping the balanced risk profile. This is the engine behind funds like Bridgewater's All Weather.

The limitations to respect

Risk parity leans heavily on bonds, so it suffers when bonds and stocks fall together (as in 2022's rate shock) — the diversification it assumes can vanish. The required leverage adds financing cost and a path to forced selling if volatility spikes. And like all of this, it depends on volatility and correlation estimates that are stable only until they are not.