Open Access Journal Article

A Study of Hierarchical Risk Parity in Portfolio Construction

by Debjani Palit a,* orcid  and  Victor R. Prybutok b orcid
a
Department of Information Science, University of North Texas, Denton, USA
b
Department of Information Technology and Decision Sciences, G. Brint Ryan College of Business, University of North Texas, Denton, USA
*
Author to whom correspondence should be addressed.
JEA  2024, 68; 3(3), 68; https://doi.org/10.58567/jea03030006
Received: 22 July 2023 / Accepted: 4 September 2023 / Published Online: 15 September 2024
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Abstract

The construction and optimization of a portfolio is a complex process that has been a historically active research area in finance. For portfolios with highly correlated assets, the performance of traditional risk-based asset allocations methods such as the mean-variance (MV) model is limited when numerous assets are correlated. A novel clustering-based asset allocation method, called Hierarchical Risk Parity (HRP), provides an opportunity to mitigate these limitations in portfolio construction. HRP utilizes the hierarchical relationships between the covariance of assets in a portfolio to determine weight distributions, eliminating the need for the inversion of the covariance matrix that is required by most traditional risk-based asset allocation methods. This research examines the viability of Hierarchical Risk Parity (HRP) method in portfolio construction of a US equity portfolio and compares the performances of HRP to traditional asset allocation methods exemplified by the mean-variance (MV) method. The results of this research show that the performance of the HRP method is comparable to the performance of the MV method. Given these findings, HRP provides an advantageous approach for portfolio construction in practical scenarios where correlated assets are present in the portfolios.

Keywords: Hierarchical clustering; hierarchical risk parity; mean-variance method; portfolio construction; machine learning in finance;
Copyright: © 2024 by Palit and Prybutok. This is an open-access article distributed under the terms of the Creative Commons Attribution License (CC BY) (Creative Commons Attribution 4.0 International License). The use, distribution or reproduction in other forums is permitted, provided the original author(s) or licensor are credited and that the original publication in this journal is cited, in accordance with accepted academic practice. No use, distribution or reproduction is permitted which does not comply with these terms.
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ACS Style
Palit, D.; Prybutok, V. R. A Study of Hierarchical Risk Parity in Portfolio Construction. Journal of Economic Analysis, 2024, 3, 68. https://doi.org/10.58567/jea03030006
AMA Style
Palit D, Prybutok V R. A Study of Hierarchical Risk Parity in Portfolio Construction. Journal of Economic Analysis; 2024, 3(3):68. https://doi.org/10.58567/jea03030006
Chicago/Turabian Style
Palit, Debjani; Prybutok, Victor R. 2024. "A Study of Hierarchical Risk Parity in Portfolio Construction" Journal of Economic Analysis 3, no.3:68. https://doi.org/10.58567/jea03030006
APA style
Palit, D., & Prybutok, V. R. (2024). A Study of Hierarchical Risk Parity in Portfolio Construction. Journal of Economic Analysis, 3(3), 68. https://doi.org/10.58567/jea03030006

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