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CFA Level III · Level III Core

Overview of Asset Allocation for CFA Level III

Asset allocation is the process of dividing a portfolio across asset classes so it meets a client's objectives and constraints. At Level III you must choose an approach (asset-only or liability-relative), build the allocation, set risk budgets, implement it and rebalance. Always tie each step to the client's needs.

What this chapter covers

This chapter is the base of the Asset Allocation topic. It starts with the client's full financial picture, the economic balance sheet, and moves to how that picture shapes the strategic asset allocation (SAA). You then compare asset-only and liability-relative approaches, study mean-variance optimization and its weaknesses, look at risk budgeting and other ways to build an allocation, and finish with implementation and rebalancing.

The chapter is about judgment as much as technique. Each method has a purpose, a set of assumptions and a set of weaknesses. The exam rarely asks you to run an optimizer. It asks which approach suits a given client and why, what is wrong with an output, or how to act when markets move.

The ideas carry into the rest of the paper. Later chapters on asset allocation with real-world constraints, portfolio construction, derivatives and risk management, and the pathway material all assume you can state the client's objectives and constraints and pick a fitting allocation approach. Think of this chapter as the framework that later chapters fill in.

Asset Allocation is one of the largest topics in the Level III common core, and its ideas appear in item sets and essay sets across the paper, including in pathway material. Each item set is worth 12 points and each essay set is also worth 12 points, so a clear grasp of approach selection and justification pays off repeatedly. Because there is no minimum score per topic, strong marks here can offset weaker areas elsewhere. The chapter also rewards short, reasoned answers: if you can name the right approach and give one or two precise reasons tied to the client, you earn the points.

Overview of Asset Allocation: topics in the order to study them

  1. 1Economic Balance Sheet and Asset AllocationIt defines the client's total assets and liabilities, including human capital, so every later choice has a starting point.
  2. 2Asset-Only vs Liability-Relative ApproachesOnce you know the client's liabilities, you can decide whether to focus on assets alone or on funding those liabilities.
  3. 3Mean-Variance Optimization and Its LimitationsThis is the main asset-only tool, and you need it before you can judge its flaws and the alternatives.
  4. 4Risk Budgeting and Asset Allocation AlternativesIt answers the weaknesses of mean-variance optimization with other ways to build and size an allocation.
  5. 5Strategic Asset Allocation Implementation and RebalancingIt comes last because it puts the chosen allocation into practice and keeps it on target over time.

How to prepare Overview of Asset Allocation

Prepare this chapter by linking each method to the type of client it suits. Memorizing lists is not enough; you must be able to justify a choice.

  1. Read the first topic and write a client's economic balance sheet in your own words, listing financial capital, human capital and liabilities.
  2. Build a two-column comparison of asset-only and liability-relative approaches: objective, risk measure, typical client, and when each fits.
  3. List the inputs and assumptions of mean-variance optimization, then note each limitation and what it does to the output, such as concentrated portfolios and sensitivity to inputs.
  4. Compare risk budgeting and the other allocation alternatives by asking what each fixes and what it still leaves open.
  5. Study rebalancing as a trade-off between tracking the target and paying costs; practise explaining when to rebalance and why.
  6. Do item sets and essay questions under time, writing short answers that name the approach and give reasons tied to the client. Show any calculation so the number is clear.
  7. Review every error and note whether it came from a wrong approach choice, a missed client constraint, or a command-word slip.

Common mistakes in Overview of Asset Allocation

  • Treating the client's portfolio as the whole picture and ignoring human capital and liabilities.

    Fix: Begin every case by listing the full economic balance sheet and ask how each item affects risk and return needs.

  • Choosing an approach without tying it to the client.

    Fix: Finish each answer with a reason drawn from the vignette, such as a fixed obligation or a long horizon.

  • Listing mean-variance limitations without explaining their effect.

    Fix: For each limitation, state the consequence, for example that input sensitivity can swing weights sharply.

  • Confusing allocating capital with allocating risk.

    Fix: Remember that risk budgeting sets how much risk each part may use, which can differ from its capital weight.

  • Giving more or fewer responses than the essay asks for.

    Fix: Give exactly the number requested, in the order asked, because only those are evaluated.

  • Treating rebalancing as a rule rather than a trade-off.

    Fix: Compare costs, drift and risk control, and match the policy to the client's circumstances.

Last-day revision: Overview of Asset Allocation

  • The economic balance sheet includes human capital and other non-traded assets, not just the investment portfolio.
  • Asset-only approaches focus on the asset side; liability-relative approaches focus on funding liabilities.
  • Liability-relative approaches suit clients with defined obligations to meet.
  • Mean-variance optimization needs expected returns, volatilities and correlations as inputs.
  • Mean-variance outputs are very sensitive to small changes in the inputs.
  • Unconstrained mean-variance optimization can produce concentrated, unintuitive portfolios.
  • Risk budgeting allocates risk, not just capital, across parts of the portfolio.
  • Every allocation approach must be matched to the client's objectives and constraints.
  • Rebalancing returns the portfolio to target weights and has costs as well as benefits.
  • Wider rebalancing ranges mean fewer trades but more drift from the target.
  • Follow the command word: state, justify or calculate each ask for something different.
  • There is no penalty for wrong answers, so always attempt every item.

Overview of Asset Allocation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Overview of Asset Allocation: frequently asked questions

How much of Level III is Asset Allocation?

Asset Allocation carries a topic weight of 15-20% of the Level III exam. Its ideas also feed into portfolio construction and pathway questions, so it is worth strong effort.

Do I need to calculate a lot in this chapter?

Not usually. Most questions test which approach fits a client and why. When a calculation is asked, show your steps; a correct number typed on its own earns full credit in an essay.

What is the best way to answer a justify question here?

Name the approach or action, then give the specific reason from the client's facts. Keep it short and match the number of reasons the question asks for.

Is this chapter the same for all pathways?

Yes. Asset Allocation is part of the common core, so every candidate studies it whichever pathway they chose at registration.