Risk budgeting allocates the portfolio's risk budget among components so that each contributes a specified share of total risk. The total risk is typically measured by volatility or downside risk, and the sum of all components' risk contributions equals the portfolio's overall risk.
Asset weights are chosen to align each component's marginal risk contribution with its assigned risk budget. This often involves an optimization process that targets a given risk budget while meeting other constraints, such as liquidity or capital requirements. Practitioners can use static budgets, updated periodically, or dynamic budgets that shift with market conditions, correlations, or risk tolerance. In multi-asset portfolios, risk budgeting can complement methods like risk parity or volatility targeting by emphasizing how risk, rather than dollar allocations, is allocated across holdings.
Estimation error in risk measures and changing correlations can cause budgets to drift. Backtesting and robust risk modeling are important, and results depend on the chosen risk measure, horizon, and constraints. Risk budgeting does not guarantee returns or protection against losses and should be supported by governance and clear risk limits.
Risk budgeting is a framework within risk-based portfolio construction that emphasizes controlling risk contributions to achieve diversification and adherence to a defined risk profile.
In a multi-asset portfolio, a manager assigns higher risk budgets to components with lower marginal risk and lower budgets to riskier components so that total portfolio risk remains within the target.
risk parity · volatility targeting · portfolio optimization · diversification · risk measure · capital allocation · marginal risk contribution