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Trading Strategies

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Volatility Weighted Portfolio Construction

Volatility-weighted portfolio construction

Portfolio OptimizationAll Asset Classes

Key Insights

Allocates capital inversely proportional to asset volatility for equal risk contribution
Basic formula: w_i = (1/σ_i) / Σ(1/σ_j) where σ_i is asset volatility
Risk parity ensures each asset contributes equally to total portfolio risk
Advanced implementations use optimization to account for correlations
Automatic rebalancing as volatilities change over time
Typically reduces portfolio volatility by 20-40% compared to equal weighting
Improves risk-adjusted returns through better risk distribution
Prevents high-volatility assets from dominating portfolio risk
Requires regular volatility estimation and rebalancing procedures
Most effective when assets have significantly different volatility profiles

Risk Parity Through Volatility Weighting

Volatility weighted portfolios allocate capital inversely proportional to asset volatility, creating equal risk contributions across portfolio components. This approach aims to improve risk-adjusted returns by ensuring no single asset dominates portfolio risk.

This method equalizes risk by assigning weights inversely proportional to volatility, ensures equal risk contribution from each asset (risk parity), reduces concentration by preventing high-volatility assets from dominating risk, and improves diversification through more balanced risk exposure.

The approach is particularly valuable for creating balanced portfolios where traditional market-cap weighting would result in concentrated risk exposure to high-volatility assets.