In short
- Risk weights can differ sharply from capital weights.
- Component contributions link weight with marginal portfolio impact.
- Define the risk measure and breach process before setting budgets.
- Contributions drift as volatility and correlation change.
After this lesson you can
- Explain why capital weights and risk contributions differ
- Calculate a simple component risk contribution
- Use a risk budget as a governance constraint rather than a return forecast
Equal dollars do not mean equal risk
A risk budget sets the total risk the portfolio can bear and allocates portions to sources such as asset classes, factors or strategies. A volatile or highly correlated sleeve can contribute far more risk than its capital weight suggests. Component contribution is often expressed as weight x marginal contribution to portfolio risk. Risk budgeting decides where uncertainty is allowed to come from; it does not decide expected return by itself.
Key point: Choose the risk measure first, then monitor contributions under changing volatility and correlation.
Component contribution identity
Risk contribution_i = w_i x Marginal risk_i
Suppose an illustrative portfolio risk measure is 10 units. Sleeve A contributes 6, B contributes 3 and C contributes 1. Their risk shares are 60%, 30% and 10%, even if their capital weights are equal. The contributions sum to total risk when the measure is decomposable.
When the budget moves without trading
A sleeve's volatility and correlation rise while its capital weight is unchanged.
- Recalculate marginal and component risk contributions.
- Compare the new contribution with its documented budget range.
- Identify whether shared factor exposure caused the increase.
- Decide whether to rebalance, hedge, revise the policy or accept a temporary breach under governance rules.
Common trap: treating risk estimates as fixed allocations
Risk contributions drift when prices, volatility and correlations change. Different risk measures also produce different budgets: volatility, drawdown and stress loss are not interchangeable. A budget without a measurement definition, monitoring frequency and breach process is only a number.
Practise what you just read
Take this lesson's quiz and review cards in the app, then try the idea with virtual money in paper trading. Free account, no card.
Education only, not investment advice. Examples are illustrative. Read the full disclaimer