Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the main objective of risk budgeting?

1. Maximizing returns without any risk constraints

2. Determining top-level risk and allocating it across sectors or asset classes

3. Minimizing costs involved in asset allocation

4. Improving the performance of specific investments

The correct answer is: Determining top-level risk and allocating it across sectors or asset classes

The primary objective of risk budgeting is to determine the overall risk tolerance of an investment portfolio and allocate that risk across different sectors or asset classes in a strategic manner. This approach allows investors to ensure that they are taking appropriate risks in relation to their investment goals and market conditions. By establishing a risk budget, investors can identify how much risk they can afford to take overall and then distribute that risk thoughtfully among various investments. This means that some sectors may be allocated a higher risk budget based on their expected returns and volatility, while other sectors may receive a lower allocation, depending on the investor's risk tolerance and investment strategy. This method enhances the ability to manage risk effectively while pursuing desired returns. In contrast, other options focus on areas that do not encapsulate the essence of risk budgeting. Maximizing returns without considering risk constraints overlooks the fundamental principle of managing risk exposure in investment strategies. Minimizing costs related to asset allocation is more focused on efficiency rather than risk management. Improving the performance of specific investments does not align with the broader, strategic perspective involved in risk budgeting, which is more about overall allocation of risk rather than just the performance of individual assets.