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Risk Parity vs Weighted Average

Risk parity is a modern portfolio management approach that aims to balance the risks of different asset classes within an investment portfolio, rather than relying on traditional market capitalization-weighting methods. In contrast, weighted average is a more common method where the weights assigned to each asset class are directly proportional to their respective market capitalizations. This difference in risk allocation strategies can have significant implications for portfolio performance and stability.

Risk Parity: A More Equitable Approach​

The concept of risk parity was first introduced by Bruno Dupire in 2008 as a means to balance the risks within an investment portfolio. In this approach, each asset class is assigned a weight based on its volatility or standard deviation, rather than market capitalization. For example, if a portfolio includes stocks and bonds with different volatilities, the risk parity approach would allocate more weight to the bond component, as it tends to have lower volatility compared to the stock component. This results in a more balanced portfolio where each asset class contributes proportionally to the overall risk.

Weighted Average: The Conventional Method​

In contrast, the weighted average method relies on market capitalization-weighting, where larger-cap stocks receive higher weights, and vice versa for smaller-cap stocks. This approach is widely used due to its simplicity and ease of implementation. However, it has been criticized for favoring larger-cap stocks over smaller-cap stocks, which can lead to inefficient portfolio allocation.

Key Differences​

The key differences between risk parity and weighted average are:

  • Risk allocation: Risk parity allocates weights based on volatility, whereas weighted average relies on market capitalization.
  • Portfolio balance: Risk parity aims to balance the risks within a portfolio, while weighted average can lead to an imbalance of risks.

Conclusion​

Risk parity and weighted average are two distinct approaches to portfolio management. While risk parity offers a more equitable distribution of risk across different asset classes, weighted average remains a widely used method due to its simplicity. Ultimately, the choice between these methods depends on an investor's specific goals, risk tolerance, and investment objectives.