Risk Budget
An allocation framework that assigns a total permissible level of portfolio risk across asset classes, strategies, or managers.
What is Risk Budget?
A risk budget is a framework for explicitly allocating a portfolio's total allowable risk — measured by volatility, Value at Risk, tracking error, or other metrics — across asset classes, strategies, sectors, or individual managers. Rather than simply allocating capital by dollar amount, risk budgeting allocates risk capacity, ensuring that each component of the portfolio contributes a defined, manageable share of total portfolio risk. This approach prevents a single volatile asset from inadvertently dominating portfolio risk despite representing a small capital allocation. Risk budgeting is widely used by pension funds, endowments, sovereign wealth funds, and multi-manager platforms. It requires defining a total risk limit (e.g., portfolio volatility ≤ 10%), decomposing that limit across components (e.g., equities may consume 60% of the risk budget), monitoring actual risk contributions in real time, and rebalancing when actual contributions breach limits.
Example
A pension fund sets a total annual volatility target of 8%. The investment committee risk-budgets: equities receive 5.5% of risk contribution, bonds 1.5%, alternatives 1.0%. If an emerging market allocation within equities becomes more volatile due to currency turmoil and its risk contribution rises to 4.0% alone — exceeding its sub-budget — the allocation is trimmed back to restore balance.
Source: CFA Institute — Risk Management