In light of the widely diverse trading markets and instruments, traders found various portfolio diversification strategies focusing on bringing high returns with minimum risks.
Portfolio diversification has always been known as a risk management strategy and a real-life application of “putting your eggs in different baskets” distributing the trading capital on several markets and securities to spread the risk.
Today, we will discuss one renowned diversification strategy, the Risk Parity Strategy, and explain how to use it with examples.
Understanding The Risk Parity Strategy
The risk parity strategy entails distributing the risk on different instruments so that no security is highly risky and would expose the whole portfolio to aggravated losses.
This approach aims to find trading instruments that do not work in correlation with each other to avoid exaggerated risks and maximize the chances of higher returns.
Trading with this approach may include different markets like trading stocks, bonds, commodities, cryptos, etc. However, this trading strategy implies that assets respond differently to various scenarios.
You must consider two factors when using a risk parity trading strategy.
- The low-risk securities shall bring higher returns than the high-risk securities.
- The profits of trading with leverage must be higher than regular trading profits without leverage.
Essentials of The Risk Parity Strategy
The risk parity strategy is built over three essential elements that are:
- Asset Classes – Portfolio’s assets may include stocks, bonds, commodities, and other trading options like hedge funds and real estate. However, each asset is selected based on the risk it adds to the portfolio and not its value or expected returns.
- Risk Factor – The risk factor means the causes of the risk level in the portfolio, like losses from market positions, changes in interest and inflation rates, and other factors.
- Diversification – The risk parity approach entails investing in different markets and assets sourced from different countries to avoid the dangers of national economic shock or the singular economic downturn effects on the portfolio.
How to Implement Risk Parity Strategy?
The risk parity strategy is crafted differently by each trader, according to their risk tolerance and acceptable level of risk. However, building a portfolio with diversified assets by markets and geography is crucial.
One suggested approach is the all-weather portfolio, indicated by the founder of Bridgewater, Ray Dalio. This strategy entails that a portfolio must include assets that are not highly affected by economic periods, including inflation, deflation, economic growth and downturn.
This way, assets and securities remain flexible throughout economic changes, implying the following allocation.
- 30% U.S. Stocks.
- 40% Long-Term Treasury Bonds.
- 15% Intermediate-Term Treasury Bonds.
- 7.5% Commodities.
- 7.5% Gold.
Another suggestion is the permanent portfolio by an American financial advisor, Harry Browne. This approach means that a portfolio shall include two types of assets, one with a long-term upward movement and the other with short-term and more fluctuating assets.
The permanent portfolio asset allocation structure is as follows:
- 25% U.S. stock.
- 25% long-term U.S. Treasury bonds.
- 25% short-term U.S. Treasury bonds.
- 25% gold.
Both strategies dictate the inclusion of Treasury Bonds and equities because they are considered one of the safest investment options.
Bonds are safer than stocks or other trading instruments because they provide a stable stream of income paid periodically with minimum price fluctuations like stocks or commodities.
Conclusion
Risk parity is an advanced portfolio diversification strategy focusing on risk management and investing in asset classes that bring more returns than risks. There are a few approaches to asset allocation and portfolio management.
However, most strategies focus on stable assets like treasury bonds and gold, which have proven durable over the years and throughout different market changes. Therefore, this strategy ensures that a trader’s portfolio is resilient and provides steady streams of profits.
