Examples of Risk Parity Rebalancing

Introduction to Risk Parity Rebalancing

Risk parity is an investment strategy that aims to allocate risk, rather than capital, evenly across various asset classes. This approach helps investors maintain a balanced portfolio that can withstand market volatility. By rebalancing the portfolio based on risk contributions, investors can optimize returns while minimizing risk exposure. Below are three practical examples of risk parity rebalancing that illustrate how this technique can be applied in real-world scenarios.

Example 1: Balanced Risk Allocation in a Mixed Portfolio

Context

A financial advisor is managing a mixed portfolio containing equities, bonds, and commodities. The objective is to achieve a balanced risk contribution from each asset class to mitigate overall portfolio risk.

The initial allocation is:

• Equities: 60%
• Bonds: 30%
• Commodities: 10%

Example

After a year, the performance of the portfolio is as follows:

• Equities return 15% (now worth 69% of portfolio)
• Bonds return 5% (now worth 32% of portfolio)
• Commodities return -10% (now worth 9% of portfolio)

To rebalance based on risk parity, the advisor assesses the volatility of each asset class:

• Equities: High volatility (risk contribution = 70%)
• Bonds: Low volatility (risk contribution = 20%)
• Commodities: Medium volatility (risk contribution = 10%)

The advisor decides to adjust the allocations to achieve equal risk contribution:

• New Equities allocation: 50%
• New Bonds allocation: 40%
• New Commodities allocation: 10%

Notes

This example demonstrates how the advisor adjusted the portfolio to maintain an equal risk contribution. The frequent performance review ensures that the portfolio remains aligned with risk parity principles.

Example 2: Institutional Fund Risk Management

Context

An institutional fund aims to stabilize returns over a long investment horizon. The fund is diversified across global equities, real estate, and fixed income. The initial allocation is:

• Global Equities: 50%
• Real Estate: 30%
• Fixed Income: 20%

Example

After three years, the market conditions have changed:

• Global Equities return 25% (now worth 60% of portfolio)
• Real Estate return 10% (now worth 35% of portfolio)
• Fixed Income return 3% (now worth 5% of portfolio)

The fund manager calculates the risk contributions:

• Global Equities: 65% (high risk)
• Real Estate: 30% (medium risk)
• Fixed Income: 5% (low risk)

To rebalance, the manager reduces the equities allocation and increases fixed income to achieve equal risk:

• New Global Equities allocation: 40%
• New Real Estate allocation: 40%
• New Fixed Income allocation: 20%

Notes

This example underscores the importance of risk management in institutional investing. The fund manager’s regular assessment of market conditions and reallocation ensures stability and risk parity.

Example 3: Individual Investor’s Diversified Portfolio

Context

An individual investor has a diversified portfolio consisting of stocks, bonds, and alternative investments (like cryptocurrencies). The initial allocation is:

• Stocks: 70%
• Bonds: 20%
• Alternatives: 10%

Example

After two years, the performance is as follows:

• Stocks return 30% (now worth 80% of portfolio)
• Bonds return 4% (now worth 22% of portfolio)
• Alternatives return -15% (now worth 8% of portfolio)

The investor reviews the risk contributions:

• Stocks: 80% (high risk)
• Bonds: 15% (medium risk)
• Alternatives: 5% (low risk)

To rebalance, the investor shifts allocations to stabilize risk:

• New Stocks allocation: 55%
• New Bonds allocation: 35%
• New Alternatives allocation: 10%

Notes

This example highlights how even individual investors can apply risk parity rebalancing techniques. By regularly monitoring and adjusting allocations, they can effectively manage risk in their portfolios.