riskbudgeting

Risk budgeting is a portfolio construction approach in which the total risk of a portfolio is allocated to its components according to predefined budgets rather than by allocating capital alone. The central idea is that each component has a target risk contribution, and the weights are chosen so that the sum of marginal risk contributions matches the specified budgets. The risk measure used can be volatility, or downside measures such as conditional value-at-risk (CVaR).

Practitioners define a total risk level and assign budgets to assets or strategies. They then solve an optimization or apply heuristic rules to set weights so that each component’s risk contribution aligns with its budget. Common approaches include equal risk contribution (ERC) and constrained optimization that may incorporate expected return, liquidity, leverage, and regulatory limits. Budgets are monitored and rebalanced as markets move.

Applications include asset management, multi-asset funds, and enterprise risk management for projects or business units. Benefits include explicit control of risk, improved diversification, and clearer accountability for risk contributions. Risks include estimation error in inputs and risk measures, sensitivity to correlations, and potential misalignment with return objectives or tail risk; in some cases risk budgets may concentrate risk in a small number of components to meet the budgets.

Risk budgeting is closely related to risk parity and is sometimes used interchangeably. Its effectiveness depends on robust input data, sound risk measures, and appropriate governance. It does not guarantee high returns and should be integrated with broader investment objectives and stress testing.