Risk Budgeting Approach

By using shrinkage methods or by imposing weight constraints, we introduce discretionary decisions on the portfolio solution. In this case, the performance of an allocation method may be strongly different depending on the choice of the constraints. In the end, we don’t know if one allocation method is better than another, because of the portfolio method itself or because of the constraints. In this chapter, we present an allocation method requiring less discretionary inputs, namely the risk budgeting approach or the ‘risk parity ’ approach. The term risk parity is the technical term1 used in the asset management industry.