Uncertain Risk Parity

14 Pages Posted: 30 Jun 2021

See all articles by Anish Shah

Anish Shah

Investment Grade Modeling; Brown University - Division of Applied Mathematics

Multiple version iconThere are 2 versions of this paper

Date Written: January 20, 2021

Abstract

Risk parity is a portfolio construction technique that scales sections of a portfolio (eg, stocks, bonds, currencies, commodities) so that forecasted contributions to net portfolio risk match the budget. Because risks are measured from a point estimate of covariance, the method is subject to problems of estimation error. This paper treats covariance as uncertain in order to find a risk parity weighting that does not count on perfectly optimized hedges and is robust to changes in regime. Separately, of general interest are the uncertain risk contributions calculated en route. Reporting a portfolio’s uncertain risk decomposition puts a band around numbers and reveals fragility. For example, a market could seem hedged in a long–short portfolio but surface as the biggest risk when parameters are considered across their error range.

Keywords: covariance; estimation error; factor models; portfolio construction; regularization; risk parity; uncertainty.

Suggested Citation

Shah, Anish, Uncertain Risk Parity (January 20, 2021). Journal of Investment Strategies, Vol. 10, No. 1, Available at SSRN: https://ssrn.com/abstract=3875322

Anish Shah (Contact Author)

Investment Grade Modeling ( email )

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