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Risk parity is a quantitative style of portfolio asset allocation that adjusts the proportion of different asset classes in the portfolio based on their riskiness, usually defined by volatility, and the investor’s risk appetite.
The aim of risk parity funds is to achieve better diversification than traditional 60/40 allocation strategies, by earning the best return for the given volatility and riskiness of fixed income, equities, currency and commodities securities. If stocks become more volatile relative to other assets such as bonds, the weighting to stocks in the portfolio will be reduced. If they become less volatile the weighting increases, and so on.
An investor with a larger appetite for risk will most likely have a risk parity portfolio that is more weighted towards stocks, whereas an investor with a smaller risk appetite will be more heavily weighted towards capital-preserving assets like bonds.
Risk parity is an advanced portfolio technique that typically has been the domain of active managers and hedge funds although many passive indexes also take a similar approach to allocation. Bridgewater Associates pioneered the risk parity approach to investing in 1996 with the launch of the All Weather hedge fund.