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Explain risk budgets set in absolute and in relative terms, and how they guide choosing and carrying out an asset allocation

CFA® Level III · Asset Allocation · Principles of Asset Allocation · L3.AA.4.g

The idea

A risk budget sets the total risk the investor will accept and allocates it across sources. An absolute risk budget is expressed in total volatility or loss terms; a relative budget is expressed as tracking error against a benchmark, used to limit active risk. Each asset's marginal contribution to total risk equals its beta to the portfolio × portfolio volatility, and absolute contribution = weight × marginal contribution. With a 60% weight, beta of 1.2 and 10% portfolio volatility, the contribution is 0.6 × 1.2 × 10 = 7.2%, or 72% of the total. The allocation is optimal when the ratio of excess return to marginal contribution is equal across assets. The trap is equating capital weights with risk weights.

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