4 - Risk-budgeting and Risk-based Portfolios

Abstract

As discussed expected returns are much more difficult to estimate than the return covariance matrix and small estimation errors push optimizers to generate excessively concentrated portfolios. It is therefore not surprising that some portfolio construction approaches have chosen to ignore expected returns – or, equivalently, assume that all expected returns are equal – and focus exclusively on risk. These strategies are usually referred to as “risk-based” or “risk-budgeting” strategies. In this chapter, we will review four of them: the naive risk parity, the equal risk contribution, the most diversified portfolio and the minimum variance portfolio.