What is the concept of risk budgeting in portfolio construction?

• A. Risk budgeting allocates a fixed amount of portfolio risk to each asset class, guiding weightings to achieve an overall risk target while pursuing return
• B. Risk budgeting aims to maximize risk across all assets
• C. Risk budgeting eliminates the need for diversification
• D. Risk budgeting is identical to classic 60/40 allocation

Answer: (A)

Risk budgeting in portfolio construction means assigning a fixed amount of the portfolio’s risk to each asset class, not a fixed dollar amount of capital. The idea is to control the total risk first and then seek returns within that risk framework. You set a target for how much risk the whole portfolio should have, and each asset class receives a risk budget that reflects how much of that total risk you’re willing to tolerate from that asset. The actual weights of assets are chosen so that each asset’s contribution to overall risk aligns with its budget.

In practice, this uses measures like volatility and how assets move together (correlations) to calculate each asset’s marginal contribution to risk. Budgets can be equal across assets (risk parity) or tailored to preferences and constraints. The result is a portfolio that aims for a balanced risk profile rather than simply chasing high returns with fixed weights.

Why the other ideas don’t fit: risk budgeting isn’t about maximizing risk or concentrating risk in the hope of bigger gains, and diversification is still a goal to keep risk spread. It’s also not the same as a naive fixed 60/40 split, which ignores how changing volatilities and correlations affect actual risk contributions.