Explain risk budgets set in absolute and in relative terms, and how they guide choosing and carrying out an asset allocation
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.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Principles of Asset Allocation
- Explain how mean–variance optimisation is used to set an asset allocation and assess its strengths and weaknesses
- Select and defend an asset allocation using the results of mean–variance optimisation
- Analyse an asset allocation against a client's economic balance sheet and judge whether it fits
- Propose and defend an asset allocation that uses the global market portfolio as its reference point
- Explain how scenario analysis and Monte Carlo simulation are used to stress-test an asset allocation's robustness
- Explain how the liquidity of asset classes affects asset allocation decisions
- Explain how a client's requirements and attitudes toward particular investment risks can be built into an asset allocation
- Explain how investment factors are used both to build an asset allocation and to analyse one
- Assess the features of liabilities that matter for asset allocation
- Set out the main methods for allocating assets relative to liabilities
- Propose and defend an asset allocation designed around a set of liabilities
- Propose and defend a goals-based asset allocation for an individual investor
- Assess heuristic and other rule-based methods of setting an asset allocation
- Explain what determines an appropriate rebalancing policy