Chartered Financial Analyst (CFA) Practice Exam Level 2

Which of the following best describes a position limit?

1. The total amount invested in a single security

2. The maximum allocation allowed to a position or sector

3. The minimum investment required in each asset class

4. The overall risk exposure permitted for the entire portfolio

The correct answer is: The maximum allocation allowed to a position or sector

A position limit refers to the maximum allocation permitted to a specific position or sector within a portfolio. This limit is often set by regulators or internal policies of investment firms to manage risk and prevent overexposure to any single investment or sector, thereby ensuring diversification. By capping the amount that can be allocated to a single position, the firm or investor helps mitigate potential losses that could arise from concentrated investments, which can be particularly risky during market downturns. In the context of investment strategies, adhering to position limits can help maintain a balanced portfolio that is less susceptible to the volatility of any particular asset. This approach allows for more controlled risk management and ensures compliance with regulatory guidelines or risk tolerance levels established by investors. Understanding position limits is crucial as they play a significant role in shaping not only individual security selections but also broader sector exposure within a portfolio.