Risk Budgeting

What Is Risk Budgeting?

Risk budgeting is a portfolio construction framework that allocates a total portfolio risk budget across different assets, strategies, or managers. Instead of asking "how much capital to allocate," risk budgeting asks "how much risk to allocate" to each component, measured by its contribution to total portfolio volatility.

How Risk Budgeting Works

Step	Action	Example
1	Set total risk budget	12% annual volatility
2	Identify risk sources	Equity, credit, rates, alternatives
3	Assign risk budgets	Equity: 7%, Credit: 2%, Rates: 2%, Alts: 1%
4	Size positions accordingly	Adjust weights so each hits target risk contribution
5	Monitor and rebalance	Ensure risk contributions stay within bounds

Risk Budget vs. Capital Allocation

Approach	Focus	Limitation
Capital allocation	% of portfolio in each asset	Ignores that assets have different volatilities
Risk budgeting	% of portfolio risk from each asset	More precise risk management

Example

Portfolio with 12% target volatility:

• US Stocks (σ=16%): Risk budget = 6% → Weight = 37.5%
• Int'l Stocks (σ=18%): Risk budget = 3% → Weight = 16.7%
• Bonds (σ=5%): Risk budget = 2% → Weight = 40.0%
• Commodities (σ=20%): Risk budget = 1% → Weight = 5.0%

Notice: Bonds get the largest capital allocation (40%) but contribute only 2% risk, while stocks get less capital but contribute 75% of total risk.

Key Benefits

• Transparent risk decomposition: Know exactly where risk comes from
• Prevents risk concentration: A 60/40 portfolio has ~90% of risk from stocks
• Adaptable: Works with any risk measure (VaR, volatility, drawdown)
• Scalable: Applied from individual portfolios to multi-billion-dollar institutions

Why It Matters

Risk budgeting reveals the hidden reality of traditional portfolios: a "balanced" 60/40 portfolio is actually a 90% equity risk portfolio. By thinking in risk terms, investors can build truly diversified portfolios where each asset class meaningfully contributes to both risk and return.