Definition
Risk budgeting distributes a defined total risk limit across portfolio components based on expected return per unit of risk. Unlike capital allocation (which focuses on dollars invested), risk budgeting focuses on risk contribution. This ensures risk is allocated where it is best compensated. Total portfolio risk = sum of each component's risk contribution.
lightbulb Example
Total tracking error budget: 5%. Allocation: 2% to stock selection, 1.5% to sector bets, 1% to factor tilts, 0.5% to currency. Each component must generate sufficient alpha to justify its risk budget allocation.
verified_user Key Points
- Allocates risk where it is best compensated
- Total portfolio risk = sum of risk contributions
- More sophisticated than simple capital allocation
- Used by institutional investors and multi-manager portfolios