A risk parity portfolio sets asset weights so that each asset contributes a similar share of total portfolio risk, instead of giving each asset the same dollar amount. The simplest version in Excel is inverse-volatility weighting: weight of asset i = (1 / volatility of i) / sum of (1 / volatility) across all assets, so a volatile stock gets a smaller weight and a stable bond fund a larger one. Full risk parity also accounts for correlations between assets. The example below uses MarketXLS portfolio templates to compare an equal-weight portfolio with a risk-reduced reweighting; it is a simplified illustration on past data, not full risk parity and not investment advice.
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The MarketXLS portfolio templates calculate the ratios and metrics which include: Correlation, CAGR, Value at Risk, Portfolio Volatility, Positive Period, Portfolio Beta, Treynor Ratio, Max. Drawdown, Sharpe Ratio and Sortino Ratio.CorrelationCorrelation is a statistical measure of how two asset prices move in relation to each other. Correlation calculations are based on historical data; there is no guarantee that these correlations will continue in the future. MarketXLS has a ready-to-use template, using which you can find correlation between two assets easily.** Building a Risk-Parity Portfolio using MarketXLS**1) We have tried to build a Risk-Parity Portfolio using 4 assets (each having a weightage of 25%)
2) We will start by allocating equal weight to all these assets
3) We will use MSFT (stable), TSLA (highly volatile), an ETF and an Inflation Protected bond in our example.
4) For better simulation, we will use the period from March 2020 – February 2021.
5) A basic Investment of 7,000 USD has been taken.
Let us dive straight into the construction!
As you can see, the value of our portfolio is now $18,946 having only 8 positive periods out of 12 and a CAGR of 89.46%.
In order to aim for an improvement in the risk and growth structure, let’s dig into the correlation of all the 4 assets in the portfolio.
The Correlation between the 4 assets can be calculated using the Correlation Matrix R template.
MarketXLS provides ready-to-use templates for facilitating data collection and presentation of a Risk Parity Portfolio in an easy manner. Browse the MarketXLS template directory. In MarketXLS, there are several functions using which you will be able to compare two different kinds of portfolios in the same period or the same portfolio in 2 different periods using the “Comparisons” template
Let’s concentrate on the following points:
• In Risk Parity Portfolio, we try to reduce the risk of the asset in the portfolio. Indicator of risk is Standard Deviation. Since Tesla (TSLA) is very volatile, they have a very high standard deviation. To reduce the risk they offer, lets reduce their participation in our portfolio from 25% to 15%. This frees 10% of the total space of portfolio.
• Since Inflation Protected Bonds () have a lower CAGR than the other 2 assets which are left, we transfer the weightage of 10% from Inflation Protected Bonds to MSFT equity.
• Our software will also provide the Correlation between different assets which would facilitate you in determining the weight to be assigned to a particular asset in the portfolio. Looking at the table which shows the monthly correlation of the assets, we can see that Invesco ETF has a low correlation with the other 3 assets. As mentioned earlier, the low correlation helps in reducing the overall risk of the portfolio, we allocate the freed up 10% weightage to the Invesco Developed Markets Momentum ETF. ()
Concluding from the above three points, we can see the allocation of the new portfolio as follows:
• 15% Tesla (TSLA)
• 15% Vanguard Short Term Inflation Protected ETF (VTIP)
• 35% Microsoft (MSFT)
• 35% Invesco ETF (PIZ)
MarketXLS will now calculate the returns provided by the new Risk Parity Portfolio as compared to the Basic Portfolio. It will emphasize your focus on volatility and standard deviation, rather than on capital allocation.
MarketXLS has created a database of several templates including risk management, portfolio analysis and management and investment strategies covering how investors can manage risk across various sectors. These templates are designed in such a way that it will enable you to get all the historic as well as current information relating to all varieties of stocks.
Conclusion
Over March 2020 to February 2021, the reweighted portfolio ended at 27,559 USD versus 18,946 USD for the equal-weight version. That result is in-sample: part of the change came from shifting weight toward assets that had already performed well (MSFT and PIZ), which will not necessarily repeat. The risk-related change is the lower weight on the most volatile holding, TSLA. A true risk parity portfolio would set every weight from each asset's volatility and correlations (for example with the inverse-volatility formula above) rather than from past returns.
The pictures and graphics used were taken from this software itself – MarketXLS.
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The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein.
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