A risk analyst decomposes total portfolio variance by asset and finds that Asset A represents 25% of portfolio weight but contributes 40% of total portfolio variance. Which conclusion is most appropriate?
- AAsset A must be uncorrelated with the rest of the portfolio since its risk contribution differs from its weight.
- BAsset A's beta relative to the risk-free asset must equal exactly 1.6.
- CAsset A is a disproportionately large source of portfolio risk relative to its weight, suggesting reducing its allocation could lower total portfolio risk.
- DAsset A's marginal contribution to risk is proportionally less than its weight, so increasing its allocation would reduce total portfolio risk.
Show answer & explanationAnswer & explanation
Correct answer: C. Asset A is a disproportionately large source of portfolio risk relative to its weight, suggesting reducing its allocation could lower total portfolio risk.
Asset A's risk contribution (40%) exceeds its portfolio weight (25%), giving a risk contribution ratio of 40%/25% = 1.6. A ratio above 1.0 means the asset contributes more to total risk than its dollar allocation would suggest, often due to high volatility or high correlation with the rest of the portfolio — a key concept in risk budgeting. Reducing its weight would likely reduce total portfolio risk disproportionately.
Why the other options are wrong
- A. A mismatch between weight and risk contribution does not imply zero correlation; it could reflect high correlation or volatility.
- B. Beta relative to the risk-free asset is undefined in this context; the ratio relates to risk contribution, not beta to the risk-free rate.
- D. This reverses the relationship — the contribution ratio is above, not below, 1.0.
Risk Budgeting / Marginal Contribution to Risk
Risk budgeting allocates a portfolio's total risk across positions, identifying which assets contribute disproportionately more or less risk than their capital weight.
- Contribution-to-weight ratio > 1 = disproportionate risk source
- Driven by asset volatility and correlation with rest of portfolio
- Used to rebalance portfolios toward more efficient risk allocation
Memory trick: Small weight, big risk — the tail wagging the portfolio dog.