Portfolio construction, asset allocation and risk budgeting
This domain tests how you move from capital market assumptions to a portfolio that meets return, risk and liability constraints. The exam expects efficient-frontier reasoning, practical constraints and an explicit risk budget.
Core rules
- Strategic asset allocation sets long-term exposures; tactical allocation makes shorter-term deviations within risk limits.
- Diversification depends on correlation as well as volatility; low-correlation assets reduce portfolio risk more than their stand-alone risk suggests.
- Risk budgeting allocates risk, not just capital. A small high-volatility allocation can dominate total risk.
- Constraints include liquidity, regulatory capital, currency, concentration limits and liability matching.
- Rebalancing controls drift but incurs costs; tolerance bands are a practical compromise.
Worked example
A portfolio is 60% asset A with volatility 10% and 40% asset B with volatility 20%; correlation is 0.3. Portfolio variance is 0.36 x 0.01 + 0.16 x 0.04 + 2 x 0.6 x 0.4 x 0.1 x 0.2 x 0.3 = 0.01288, so volatility is 11.35%. Asset B has twice the stand-alone risk of A but less than half the weight, yet it contributes materially to total risk. A risk budget would measure each asset's marginal contribution to volatility, not just its weight.
Traps
- Confusing capital allocation with risk allocation.
- Assuming diversification always works in a liquidity crisis.
- Optimising on historical inputs without judgement.
- Ignoring liability constraints when presenting an efficient portfolio.