Risk parity is a portfolio allocation strategy that uses risk calibration to determine balanced allocations across various components of an investment portfolio. Risk parity was pioneered by some of the largest hedge funds in the world, and has been used to manage and grow portfolios worth hundreds of billions of dollars with great success.
To translate a risk parity approach to crypto and DeFi, it is first essential to determine what factors underpin this strategy and whether and how they can be replicated in an algorithmic and decentralized fashion.
The most successful and well-known risk parity portfolio was designed by Ray Dalio, the founder and CIO of Bridgewater Associates, the largest hedge fund in the world. He called his fund All Weather because it’s designed to succeed in any circumstances.
All Weather was designed with the following fundamentals in mind:
Seek Risk-Balancing, not Yield-Maximizing Assets. Investment assets can be compared by calibrating how much yield each asset generates on a per unit of risk basis. You can then pair assets which are negatively correlated, i.e., which generate an overall positive yield, but in opposite market conditions. For example, the prices of stock and bonds are known to move in opposite directions in times of strong corporate growth.
Figure 1: An example of positive and negative correlation of two different asset classes in different macroeconomic conditions
Balance out Environmental Sensitivity. Of course, the process is more nuanced than this. In the example above, stocks and bonds are negatively correlated in times of increased growth, but positively correlated in times of decreased inflation.
Every asset class and indeed a pair of asset classes —reacts differently to environmental biases such as economic cycles or inflation. But by selecting a sufficient number of negatively correlated pairs, the class-wide risk from each asset can offset the others while maintaining the same yields.
The resulting risk-parity portfolio will have diversified assets specifically engineered to offset risks in all possible macro-economic environments.
Figure 2: An example risk allocation to protect a portfolio of assets against shifting environmental conditions.
Diversification In traditional markets, a diversified portfolio, means diversification over stocks, bonds, and commodities. Historical data has shown two things to be true: individual stock selection (alpha) is a zero-sum game between buyers and sellers; and a market index (beta) outperforms cash (gamma) over time. In the long run, optimal selection of betas is the key driver and protector of yield in a balanced portfolio, rather than active trading.
RETURN = ALPHA + BETA + GAMMA
If we could find a way to synthesize the alpha, beta, and gamma asset classes into crypto and DeFi, it should be possible to create a risk parity portfolio that could withstand the often extreme environmental biases of the crypto market cycle.