According to the risk parity approach, how should portfolios be diversified?

The risk parity approach emphasizes that portfolios should be structured to ensure each asset contributes equally to the total portfolio risk. This methodology recognizes that different asset classes often have varying levels of risk associated with them. Therefore, instead of allocating equal capital to each asset, which would overlook their unique risk profiles, risk parity seeks to balance the risk contribution.

By diversifying in such a way, the portfolio is designed to minimize the impact of any single asset's performance on the overall portfolio, thus achieving a more stable return profile. The approach typically results in a higher allocation to lower-risk assets and a lower allocation to higher-risk assets, creating a well-balanced risk exposure across the entire portfolio.

In essence, this focus on risk contribution aligns with the goal of optimizing diversification and managing risk, making the portfolio less sensitive to adverse market movements and improving risk-adjusted returns.