In the aftermath of the financial crisis, investors and asset allocators have started the
usual ritual of rethinking the way they approached asset allocation and risk management.
Academic/Practitioner journals are full of articles that are supposed to show investors what went
wrong and how they can adjust their models and theories in order to protect themselves against
substantial losses next time equity and credit markets experience significant losses. Most of these
recommendations should be viewed with a great deal of skepticism as they are bound to
incorporate a healthy dose of data snooping and over fitting biases. For example, both Barclay
Capital Global Bond Index and MSCI World Equity Index have earned about 7% annual nominal
return since 1990, with volatility of the bond index being about 1/3 of the volatility of the equity
index. Clearly, going forward it is all but impossible for the bond index to repeat the
performance of the last 20 years.1 Therefore, any model that would recommend a significant
allocation to fixed instruments should be carefully analyzed and its assumptions should be
questioned.
The so-called risk parity approach to asset allocation has enjoyed a revival during the last
few years because such a portfolio would have outperformed the “normal” portfolios with their
typical significant allocations to equities. In this note, we discuss the risk parity approach to asset
allocation and examine its underlying assumptions. The central idea of the risk parity approach is
that in a well-diversified portfolio all asset classes should have the same marginal contribution to
the total risk of the portfolio. For example, as shown below, in a typical 60/40 portfolio, equity
risk accounts for almost 90% of the total risk of the portfolio, which is significantly higher than
its weight, 60%. Under the risk parity approach, there is generally a significant allocation to low
risk asset classes and allocations to equities and other risky assets are typically below what we
normally observe for most diversified institutional quality portfolios. Therefore, we want to
know if this approach is based on sound economic and financial reasoning or is it just another
attempt to extr**late the results of the last ten years into the future.