Journal of Economics and Financial Analysis, 3 (1), pp. 71-85, [2019]
URI: https://ojs.tripaledu.com/index.php/jefa/article/view/44/48

A Modified Risk Parity Method for Asset Allocation




DOI: http://dx.doi.org/10.1991/jefa.v3i1.a24

Abstract

We propose a return based modification of the portfolio variance matrix for asset allocation using risk parity. The modification is based upon a single scalar parameter which can be tuned to tailor the allocation for desired expected risk and/or return. The present work contributes a new twist on risk parity. While classical risk parity methods are based exclusively on volatility, the new solution (Modified Risk Parity) considers both historical returns and their variance in the construction of an optimal, diversified investment portfolio. We present two examples for periods including the recent financial market crises. The results suggest that the modification may lead to significantly improved risk adjusted returns over those realized by the conventional risk parity method.

Keywords

Risk Parity; Asset Allocation; Decision Making; Portfolio Optimizaion.

JEL Classification

G11, G12, D81.

Full Text:


References

Benartzi, S., and Thaler, R. (2001). Naive diversification strategies in defined contribution saving plans. American Economic Review, 91(1), pp. 79-98.

Chaves, D.B., Hsu, J.C., Li, F., and Shakernia, O. (2012). Efficient algorithms for computing risk parity portfolio weights. Journal of Investing, 21(3), pp. 150-163.

Clarke, R., de Silva, H., and Thorley, S. (2012). Risk parity, maximum diversi- fication, and minimum variance: An analytic perspective. Journal of Portfolio Management, 39(3), pp. 39-53.

Haugen, R., and Baker, N. (1996). Commonality in the determinants of expected stock returns. Journal of Financial Economics, 41(3), pp. 401-439.

Maillard, S., Roncalli, T., and Teiletche, J. (2010). The properties of equally weighted risk contributions portfolios. Journal of Portfolio Management, 36(4), pp. 60-70.

Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), pp. 77-91.

Merton, R. (1980). On estimating the expected return on the market: An exploratory investigation. Journal of Financial Economics, 8(4), pp. 323-361.

Michaud, R.O. (1989). The Markowitz optimization enigma: is optimized optimal? Financial Analysts Journal, 45(1), pp. 31-42.

Qian, E. (2005). Risk parity portfolios: Efficient portfolios through true di- versification. White paper, Panagora Asset Management.

Qian, E. (2006). On the financial interpretation of risk contribution: Risk budgets do add up. Journal of Investment Management, 4(4), pp. 41-51.




Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.