How is "risk parity" defined as an investment strategy?

Risk parity is defined as an investment method that allocates risk equally across various asset classes, which distinguishes it from traditional asset allocation strategies that typically focus on allocating capital based on expected returns. In risk parity, the approach aims to balance the contribution of risk from each asset class, regardless of its individual volatility or historical performance.

The strategy is predicated on the understanding that different asset classes exhibit differing levels of risk and return characteristics. By ensuring that each asset contributes equally to the overall portfolio risk, investors aim to enhance the risk-adjusted returns of the portfolio. This often involves using leverage to increase exposure to lower-risk asset classes, allowing for an equal risk contribution across the portfolio without overly concentrating risk in any single area.

This effective diversification reduces the overall volatility of the portfolio, leading to potentially more stable returns over time. Such an allocation can help investors navigate different market conditions more effectively, as it does not depend solely on the performance of a single asset class.