Reviewed by Gotrade Internal Analyst
Risk parity is a portfolio construction method that allocates based on risk contribution rather than capital weight. Instead of dividing money equally or following a traditional stock-bond split, risk parity aims to ensure each asset class contributes an equal share of total portfolio risk. The idea is that balance should be measured in units of risk, not dollars.
Traditional portfolios often look balanced on the surface but carry hidden concentration. A 60/40 stock-bond portfolio, for example, derives the vast majority of its volatility from the equity side. Risk parity attempts to correct this imbalance by sizing positions according to how much risk each asset brings to the table.
How Risk Is Distributed Across Assets
In a risk parity framework, the portfolio weights each asset so that its contribution to overall portfolio risk is roughly equal. This means lower-volatility assets like bonds receive larger allocations, while higher-volatility assets like equities receive smaller ones.
Why volatility drives weight
Stocks are typically two to three times more volatile than government bonds. In a traditional 60/40 portfolio, equities can account for 85 to 90 percent of total portfolio risk despite representing only 60 percent of capital. Risk parity flips this by giving more weight to the less volatile asset until risk contributions equalize. The result is a portfolio that does not depend on any single asset class to drive or drag performance.
The role of correlation
Risk parity also accounts for how assets move relative to each other. Assets with low or negative correlation reduce total portfolio risk when combined. If stocks and bonds tend to move in opposite directions during stress, combining them in a risk-balanced way can smooth returns more effectively than capital-weighted approaches.
Difference From Traditional Allocation
Traditional asset allocation divides capital by percentage. An investor might hold 60 percent stocks, 30 percent bonds, and 10 percent alternatives. The split looks diversified, but risk is not evenly spread. Because equities are more volatile, they dominate the portfolio's behavior in both rallies and drawdowns.
Risk parity shifts the question from "how much money goes where" to "how much risk comes from where." This distinction matters because two portfolios with identical capital allocations can behave very differently depending on the volatility and correlation of their holdings.
A risk parity portfolio may hold 25 percent equities and 55 percent bonds by capital, yet both asset classes contribute equally to overall risk. Some implementations use modest leverage on the bond allocation to bring expected returns closer to equity-heavy portfolios without concentrating risk.
If you want to explore building a diversified portfolio across US stocks and ETFs, the Gotrade app lets you start with fractional shares and adjust your allocation as you learn.
When Risk Parity Performs Well
Risk parity tends to do best in environments where diversification works as expected and no single asset class dominates for extended periods.
Falling or stable interest rate environments have historically favored risk parity because the larger bond allocation benefits from price appreciation. During periods of moderate growth and contained inflation, the balance between stocks and bonds tends to function smoothly, and risk parity captures this stability effectively.
Risk-off environments that hit equities hard but benefit bonds can also favor risk parity relative to equity-heavy portfolios, because the bond allocation offsets stock losses more meaningfully when it carries greater weight.
Limitations of Risk Parity
Rising rate exposure
Because risk parity overweights bonds relative to traditional portfolios, rising interest rates can hurt. When both stocks and bonds decline together, the expected diversification benefit breaks down. This was visible during 2022 when inflation-driven rate hikes caused simultaneous losses across both asset classes.
Leverage dependency
To achieve competitive expected returns with a bond-heavy allocation, many risk parity strategies use leverage. Leverage introduces borrowing costs, margin requirements, and amplified losses during periods of stress. Not all investors have access to or tolerance for leveraged strategies.
Backward-looking assumptions
Risk parity relies on estimates of volatility and correlation, typically derived from historical data. These relationships can shift. Correlations that were stable for decades may change during regime shifts, and a portfolio built on past patterns may not behave as expected in new environments. Rebalancing frequency and model sensitivity both influence how well the strategy adapts.
Conclusion
Risk parity offers a disciplined framework for building portfolios where no single asset class dominates risk. It challenges the assumption that capital weight equals risk balance and encourages investors to think about volatility and risk contribution as the true measure of diversification. However, it requires comfort with leverage, sensitivity to interest rate environments, and an understanding that historical relationships do not guarantee future behavior.
If you are interested in building a more balanced portfolio using US stocks and ETFs, the Gotrade app gives you access to fractional shares and diversified instruments to structure your investments around your own risk capacity.
FAQ
What is risk parity in simple terms?
Risk parity is a portfolio strategy that sizes positions so each asset class contributes equally to total portfolio risk, rather than allocating by dollar amount.
Does risk parity always use leverage?
Not always, but many implementations use leverage on lower-volatility assets like bonds to bring expected returns in line with traditional portfolios.
Is risk parity better than 60/40?
Neither is universally better. Risk parity tends to perform more consistently across different environments, but can underperform during sustained equity rallies or rising rate periods.
References
- Investopedia, Understanding Risk Parity: Strategies and Real-World Examples, 2026.
- CFA Institute, Risk Parity Made Easy, 2026.
