Advances in Portfolio Risk Control: Risk! Parity?

Abstract

Spurred by the increased interest in applying “risk control” techniques in an asset allocation context, we offer a practitioner’s review of techniques that have been newly proposed or revived from academic history. We discuss minimum variance, “1/N” or equal-weighting, maximum diversification, volatility weighting and volatility targeting – and especially equal risk contribution or “risk parity”, a concept that has become a real buzz word. We start from a taxonomy of risk control techniques. We discuss their main characteristics and their pluses and minuses and we compare them against each other and against the maximum Sharpe Ratio criterion. We illustrate their implications by means of an empirical example. We also highlight some key papers from the vast and still growing literature in this field. All in all, we aim to provide a practical and critical guide to risk control strategies. It may help to demystify risk control techniques, to appreciate both the “forest” and the “trees”, and to judge these techniques on their potential merits in practical investment applications.

Keywords: risk budgeting, risk control, risk parity, volatility weighting, diversification, portfolio optimization

JEL Classification: G11, G12