Risk parity

Most portfolios are described by where the money sits: so much in equities, so much in bonds. A 60/40 portfolio sounds balanced because the capital looks balanced. Risk parity starts from a different question — not where the money sits, but where the risk sits — and the two answers are rarely the same.

What risk parity is

Risk parity is a way of sizing positions by their contribution to total portfolio risk rather than by their share of capital. Each sleeve is measured by its marginal contribution to risk — how much it adds to the portfolio's overall volatility, a function of its own volatility, its correlation to the rest of the book, and its weight. Weights are then set so that those contributions are balanced, so no single sleeve dominates the outcome. It is diversification measured in units of risk, not units of currency.

Why a balanced-looking portfolio usually isn't

The clearest illustration is the conventional balanced portfolio. Because equities move roughly twice as much as high-grade bonds, a portfolio split evenly by capital is dominated by equity risk; the foundational risk-parity literature shows a 50/50 split is effectively around 90 percent equity risk, and on the standard worked example a 60/40 portfolio draws close to 90 percent of its risk from the equity sleeve. The bond allocation is real on the statement, but it is doing far less than its capital share suggests to change how the portfolio actually behaves.

A 60/40 portfolio is balanced by capital and lopsided by risk. Sizing by capital tells you what you own; sizing by risk tells you what will move you.

This matters because the sleeve that dominates the risk dominates the drawdowns. When equities fall, a capital-balanced portfolio falls with them, and the diversification that looked reassuring on paper provides little of the offset it promised. It is the same habit of mind set out in a high yield is not diversification: the unit of analysis should be the risk an exposure carries, not the label or weight it wears.

Balancing risk, and the role of leverage

Equalising risk contributions tends to raise the weight of the lower-volatility, more-diversifying assets and lower the weight of the dominant one. To balance risk this way without giving up expected return, the established approach is to take the more risk-balanced portfolio and scale its overall risk level, rather than concentrating back into the single highest-returning asset. The canonical argument in the risk-parity literature is that scaling a well-diversified portfolio keeps the better-diversified mix, whereas concentrating to reach the same return deliberately gives diversification away. The trade-off is explicit: any use of scaling introduces its own risks and has to be governed by hard limits, not left to discretion.

How B.U.Y. uses it

Risk-based sizing is one of the founding principles of the Basic Strategy: position sizing uses historical volatility so that exposures are balanced by risk rather than by capital, across asset classes and geographies aligned to the prevailing economic regime. In practice this means we look for genuinely different risk sources — government duration, gold, and other exposures that have historically behaved differently from equities under stress — and size each by its contribution to total risk, so the equity sleeve does not silently set the whole result. Where a low-volatility exposure such as government duration would otherwise contribute too little, we size it up to carry a risk share comparable to a conventional bond allocation, within mechanical drift bands and leverage limits that are applied by rule rather than by view.

The point of construction is not to be balanced on the page but balanced in the experience. Our equity selection still does its own work on business quality and valuation; risk parity governs how the sleeves fit together so that one environment does not decide everything.

What it does and does not promise

Risk parity is a construction discipline, not a forecast and not a guarantee. It does not predict which environment is coming, and it does not remove the possibility of loss; correlations can shift, and a period in which every major asset falls together is precisely the regime it cannot fully hedge. What it offers is a portfolio whose outcome is not quietly hostage to a single sleeve. As a measure of behaviour through one difficult year, in 2022 the conventional 60/40 reference we publish fell roughly 10 percent over the year while the strategy finished modestly higher — past performance is not indicative of future results, and a single year is context, not proof.

This page is general information and education for professional and institutional investors — not investment advice, a personal recommendation, or a financial service within the meaning of the Swiss Financial Services Act (FinSA). Diversification does not ensure a profit or protect against loss. It is written by Flavio Melis, founder of B.U.Y. INVEST.