Free CFA Level III: Private Wealth Asset Allocation Practice Questions

A is correct. Risk budgeting treats risk as a scarce resource and allocates it purposefully across asset classes, strategies, or factors. Each asset class receives a "risk budget" representing its allowed contribution to total portfolio risk. This approach ensures that risk is deployed where it is most likely to be compensated. For example, an investor might allocate 60% of the total risk budget to equities, 20% to credit, and 20% to alternatives, reflecting the expected risk-return tradeoff in each area.

Choice C is incorrect because a maximum daily dollar loss limit describes a value-at-risk or stop-loss trading constraint, not strategic risk budgeting. Risk budgeting operates at the strategic asset allocation level and considers the total portfolio risk contribution of each asset class, not daily trading limits.

Choice B is incorrect because equal portfolio weights (1/N) do not equate to risk budgeting. In equal weighting, higher-volatility asset classes contribute disproportionately more to total portfolio risk. Risk budgeting explicitly accounts for the different volatilities and correlations of asset classes, potentially leading to unequal portfolio weights to achieve the desired risk allocation.

B is correct. The optimal corridor width involves a tradeoff between the cost of rebalancing (transaction costs, taxes, market impact) and the cost of portfolio drift (deviation from the target risk profile). When transaction costs are high for a particular asset class (e.g., private equity, real estate, or emerging market equities), wider corridors are appropriate because the savings from avoiding frequent costly trades outweigh the benefit of tighter portfolio alignment.

A is incorrect. Lower-volatility assets drift less quickly from targets (their weights change more slowly), which argues for narrower corridors (since they will be hit less frequently) or the same corridor width. Higher-volatility assets drift more quickly and would trigger narrow corridors more frequently, making wider corridors more appropriate for high-volatility assets.

C is incorrect. Higher correlation with the rest of the portfolio means that the asset class moves in the same direction as the portfolio, which has mixed implications for rebalancing. The relevant factors for corridor width are transaction costs, asset class volatility, and the correlation between asset classes (higher correlation between classes argues for wider corridors because drift in one asset tends to be offset naturally by drift in correlated assets).

C is correct. On the economic balance sheet, the entrepreneur's total wealth includes both financial assets and human capital. Since the human capital (future earnings from tech work) and private company equity are both highly correlated with the technology sector, the investor's total economic balance sheet is already heavily concentrated in tech risk. To achieve diversification at the total-wealth level, the financial portfolio should underweight technology equities and overweight uncorrelated or negatively correlated assets (bonds, non-tech sectors, real estate, international equities). This is a direct application of the economic balance sheet framework.

Choice B is incorrect because concentrating the financial portfolio in technology equities would compound the existing concentration, creating extreme risk. If the tech sector experiences a downturn, the entrepreneur could simultaneously face declining company value, potential job loss, and a depressed financial portfolio. Expertise in a sector does not justify concentration — diversification is especially important when human capital is sector-concentrated.

Choice A is incorrect because while human capital cannot be traded and is difficult to value precisely, it is a real and significant asset on the economic balance sheet. For a 40-year-old, human capital represents decades of future earnings. Ignoring it leads to suboptimal financial portfolio decisions that fail to account for the investor's true total-wealth risk exposure.