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.

Click here to read the full story on Iris.xyz.