Traditional approaches to asset allocation, such as the 60/40 equity/bond blend, can lead to a disproportionate allocation of risk across asset classes, with equities taking up most of the risk allocation.
So what does it mean to be truly well-diversified? Risk parity strategies seek to answer this question by acknowledging (1) that asset class returns are generally proportional to the risk taken, (2) that a diversified portfolio of relatively uncorrelated assets may reduce risk without foregoing return, and (3) that different economic cycles expose different asset classes to different levels of risk.
By balancing risk contribution from a mix of assets and applying leverage to the overall portfolio, these strategies may help to meet the twin challenges of achieving higher returns and reducing risk in a diversified portfolio. Due to their complexity, however, it can be difficult to appropriately measure their success.
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Authors: Berlinda Liu, CFA, Director, Global Research & Design, [email protected]; Phillip Brzenk, CFA, Director, Global Research & Design, [email protected]; Matthew Brown, President and COO, MSR Indices, LLC, [email protected]; Michael Rulle, Founder and CEO, MSR Indices, LLC, [email protected]view more white papers
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