What is Risk Budgeting?
Risk budgeting sets a total risk budget for the portfolio and allocates it across asset classes based on their risk contribution rather than their dollar weight. A traditional 60/40 stock/bond portfolio appears diversified by capital, but approximately 90% of its risk comes from stocks. Risk budgeting makes this hidden concentration visible and provides a framework for truly balanced diversification.
Risk Parity
Risk parity is the most prominent application of risk budgeting. It equalizes risk contribution from each asset class. Since stocks are roughly three times more volatile than bonds, risk parity holds three times more bonds than stocks, resulting in allocations like 25% stocks and 75% bonds. Ray Dalio's Bridgewater All Weather fund pioneered this approach, delivering competitive returns with significantly lower drawdowns than traditional portfolios.
Practical Takeaways
Full risk budgeting requires sophisticated calculations, but the concept is valuable for any investor. Knowing that your 60/40 portfolio derives 90% of its risk from stocks helps you assess whether that matches your true risk tolerance. Increasing bond allocation or selecting lower-volatility equities can reduce this concentration without abandoning growth potential entirely.