What is the best approach to investing? Making investments in real estate? Or the stock market? Or putting your money in the foreign exchange market? Maybe a little bit of crypto? Well, hold your horses. Because, sadly, it is not that easy.
When it comes to investment, there are old track records of investment schools of thought. That’s right. There are schools of thought when it comes to investing and risk parity is one of those schools.
But what exactly is risk parity? In fact, what are the other methods or approaches to investment? Which one is better? How do they work? Let’s talk about approaches to investment, in particular risk parity.
What Is the Definition of Risk Parity?
Risk parity is a form of investment or more precisely a method for the allocation of your assets. In layman’s terms, it is a method that tells you in which baskets to put your eggs!
This method of asset allocation works based on the degree of percentage of risk that is associated with specific assets and types of assets.
Risk parity will calculate how stable a certain class of assets really is. How will they hold up under market volatilities and such? And then based on those calculations it defines where you should allocate your assets.
How Does Risk Parity Work?
The way risk parity works is how it is set aside from other methods of investment.
The most important mechanism behind risk parity is the way it calculates risk. This method relies heavily upon quantitative methodologies. This means there is a lot of mathematics and especially statistics involved in this method.
Risks associated with various asset classes and financial markets for investment are literally calculated and not just evaluated based on ballpark figures.
This is what makes risk parity among the most advanced approaches to investment.
So with risk parity, as the name might suggest, risk comes first and then returns on investment are considered. This is how you are assured that any return is proportional to the risk that is taken for that portion of the investment.
What Trading Methods Are Used in Risk Parity?
The most important methods that are used in risk parity investment have to do with the calculation of risk. The reason is that risk parity, unlike other forms of investment that put returns first, risk parity puts risk first. And after risk is calculated, return is evaluated based on the amount of risk.
This amount of risk is calculated from two perspectives. First of all, the amount of risk that is associated with the specific market in which investment is going to be made – i.e. the type of asset.
Secondly, the amount of risk the trader is going to take. This method is so unique that it distinguishes risk parity from other methods of investment.
So in this way, when we compare this method with other methods of investment we can see just how different it can be.
For example, the 60/40 or the MPT methods only focused on diversification. But risk parity could be extremely different from one investor to another. For instance, an investor who is seriously risk averse could be advised to invest 80 percent in bonds, which minimizes risks more than anything else.
On the other hand, if another trader or investor is more likely to take risk then they can be advised through this method to invest 80 percent in stocks, which is much more volatile than bonds.
What Is the Purpose of Risk Parity?
What you need to know about risk parity is to first you need to compare with traditional methods of investment. What did they tell you? For instance, one of the oldest methods of investment was the 60/40 method, which simply told investors that they should put 60 percent of their assets in the stock market and the rest of the 40 percent in bonds, usually backed by the government.
Clearly, that is insanely dated and out of touch with reality.
Today, we have so many different financial markets. Some of them work in virtual markets that people have not been traditionally associated with. This would include both the crypto market and even the almighty forex market.
So the main purpose of the risk parity approach is to provide an investment approach for your capitals and assets that actually works in today’s hectic market.
So, unlike traditional investment approaches, risk parity is NOT one size fits all. Instead, depending on your assets, your own personal preferences, and the markets in which you want to invest, risk parity can provide you with the desired method of investment.
Advantages and Disadvantages of Risk Parity
The most significant advantage of risk parity is how it achieves diversification through risk management. It is not a conservative approach to investment. In fact, when it has calculated the amount of risk that is allowed for the portfolio at hand and then it has calculated profit targets, it can even work with leverage and employ leverage trading to hit the profit targets.
There is also a downside to risk parity. The main disadvantage that is associated with risk parity is using assets with a lower degree of risk as their leverage, which although have a lower risk, they might change at any time in the future.
Risk Parity vs. Modern Portfolio Theory
Our main character for this article, i.e. risk parity, is usually compared and contrasted against Modern Portfolio Theory otherwise known as MPT.
We already discussed risk parity at length. But let’s take a quick look at Modern Portfolio Theory and see how it differs from risk parity.
The reason that these two approaches to investment are often compared with each other is that they both look at the role that risk plays in how your investments will turn out in the end.
Of course risk parity does this so much better than its rather older counterpart.
The way Modern Portfolio Theory calculates risk by first and foremost looking at the total and aggregate of return that can be earned through all the investment.
On the other hand, Modern Portfolio Theory does not calculate risk as directly as risk parity approach. However, MPT will try to lower the degree of risk through diversifying assets.
By putting assets in as many different financial instruments as possible, this approach attempts to minimize risks as much as possible.
Risk parity is one of the most advanced approaches to investment that takes a lot of the features from the other conventional methods of investment. First and foremost, it takes portfolio diversification and takes it to a whole other level. In addition to diversifying assets, risk parity calculates the degree of risks with asset classes and various investments better than any other method.