The Leverage Paradox: Risk Parity Strategy
The Leverage Paradox: Risk Parity Strategy
Stop allocating capital; start allocating risk. How to use modest leverage to make safe assets perform like growth assets.
Executive Summary
- The 60/40 Flaw: In a traditional 60/40 portfolio (60% Stocks, 40% Bonds), **90% of the risk** comes from stocks. This is not diversification; it is a hidden equity bet.
- Risk Parity: This strategy allocates risk equally. Since bonds are less volatile than stocks, you must hold *more* bonds (or use leverage) to equalize the risk contribution.
- The Leverage Tool: By applying 1.2x to 1.5x leverage to the low-volatility assets (Bonds/TIPS), you match equity returns with a significantly higher **Sharpe Ratio**.
The “Correlation Crunch”
Risk Parity relies on stocks and bonds moving inversely (negative correlation). In high-inflation environments (like 2022), both asset classes can fall simultaneously. You must hedge this with Commodities or Gold.
Mechanic: Balancing the Volatility
Equal
Risk Budget
1.2x-1.5x
Leverage Ratio
High
Sharpe Ratio
Hedge
Commodities
Simulation: Risk Contribution (60/40 vs. Risk Parity)
Where is your Risk coming from?
| Feature | Traditional (60/40) | Risk Parity (All Weather) |
|---|---|---|
| Allocation Basis | Capital ($$) | Volatility (Risk) |
| Primary Driver | Equity Growth | Diversification + Leverage |
| Environment | Good in Growth | Survives All Cycles |
“To make money, you need to take risks. To keep money, you need to diversify those risks. Risk Parity is the art of doing both simultaneously.”
Essential Resources
INTERNAL
BMT Playbooks
EXTERNAL
Primary Sources