As the WSJ article points out, risk-parity funds hold a significant amount of bonds (sometimes with leverage), leaving them vulnerable when stocks and bond prices fall rapidly, as happened on Friday (9/9) and Tuesday (9/13). If this occurs for a sustained period of time, they could be forced to delever and sell investments, further intensifying the sell-off.[related_stories]
Let’s take a look at how this could happen using a simple example.
Consider a basic, un-levered risk-parity portfolio which holds 25% in stocks and 75% in bonds. Say in a ‘normal’ low volatility environment, stocks exhibit a volatility of 12% and bonds 4%. Also assume that the correlation between stocks and bonds during such normal times is -0.5.
We can then calculate the volatility (or standard deviation) of this two asset portfolio as 3%.
Now, correlation is a crucial component of risk parity portfolios. To see why, let’s assume the correlation between stocks and bonds to be 0, instead of -0.5. The portfolio volatility rises to 4.2%.
In other words, we lose some of the diversification benefit if we assume stocks and bonds are completely uncorrelated with each other, as opposed to being negatively correlated.