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CFA Level III · Level III Core

Principles of Asset Allocation for CFA Level III

Asset allocation is the decision on how to split a client's portfolio across asset classes to meet their objectives and constraints. At Level III you pick an approach (asset-only, liability-relative or goals-based), build the allocation, control risk, implement it and adjust it. Always start from the client's needs.

What this chapter covers

This chapter covers how you decide what a portfolio should hold. It starts with the client's economic balance sheet, which includes human capital and other non-tradable assets and liabilities. It then compares three frameworks: asset-only, liability-relative and goals-based. Each one treats risk differently, and the right one depends on who the client is.

The chapter then moves to tools. You study mean-variance optimization and why its raw output can be unstable or concentrated. You study risk budgeting and the risk measures used in allocation. Then you cover implementation: choosing asset classes, setting strategic weights, and deciding when and how to use tactical shifts. Behavioral issues sit alongside these, because clients and managers do not always act rationally.

This chapter is the base for the rest of the core. Portfolio construction, derivatives and risk management, and the pathway topics all assume you can set a sensible allocation for a given client. Essay sets often ask you to recommend an approach, justify it, and then do a small calculation. Treat this chapter as the place where you learn to link client facts to portfolio decisions.

Asset Allocation is weighted 15-20% of the exam, making it one of the largest core topics at Level III. Its ideas feed into portfolio construction, risk management and the pathway sets. Questions are usually applied: you read a client case, choose an approach, and justify it in a few words. If you can tie each technique to the client's objectives and constraints, you earn points in both item sets and essays.

Every multiple-choice item in an item set is worth 3 points. In essay sets, the points per item are not disclosed, so you cannot judge how much an answer is worth. Answer each part precisely and concisely. There is no penalty for wrong answers, so always attempt every question.

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

  1. 1Economic Balance SheetStart here because it shows the full picture of client assets and liabilities, including human capital and other non-tradable items, which every later approach depends on.
  2. 2Asset-Only, Liability-Relative and Goals-Based ApproachesOnce you know the balance sheet, compare the three frameworks, including liability-relative allocation, and learn when each one fits.
  3. 3Mean-Variance Optimization and Its LimitationsThis is the main quantitative tool for asset-only allocation, so learn it after the frameworks and note where it fails.
  4. 4Risk Budgeting and Risk Measures in AllocationRisk budgeting builds on optimization by assigning risk, not just capital, across the portfolio.
  5. 5Strategic Asset Allocation Implementation and Asset ClassesWith the methods in hand, you can now see how weights are set and how asset classes are chosen and used.
  6. 6Tactical Asset Allocation and Behavioral ConsiderationsFinish with deviations from the strategic mix and the biases that affect decisions, since both rely on the strategic baseline.

How to prepare Principles of Asset Allocation

Study this chapter as a set of client decisions, not as a list of definitions. For each topic, ask which client it suits and why.

  1. Read the chapter once for the structure: three approaches, the tools, then implementation and tactical changes.
  2. Build a one-page table comparing asset-only, liability-relative and goals-based approaches: what risk means, who it suits and how it is implemented.
  3. Practise the calculations by hand, such as expected return and variance of a portfolio, funded status and risk contributions. Write every step so a correct number gets full credit.
  4. For each limitation or technique, write one sentence on the client situation where it helps or hurts. This is the justification skill essays test.
  5. Do item sets under time pressure. Spend about the same time per set as the exam allows, and read the client facts before the questions.
  6. Answer essay questions in full sentences that match the command word, such as calculate, justify or recommend. Give only the number of responses asked for, in the order requested.
  7. Revise using your table and a short list of formulas and biases, and redo the questions you got wrong.

Common mistakes in Principles of Asset Allocation

  • Recommending an approach without linking it to the client

    Fix: Name one client fact, such as a fixed liability or a priority goal, and state which approach it supports.

  • Treating mean-variance optimization output as a final answer

    Fix: Always state the limitation, such as input sensitivity or concentrated weights, and mention how it can be reduced.

  • Confusing strategic and tactical allocation

    Fix: Strategic is the long-term policy built from client needs; tactical is a temporary view-driven deviation from it.

  • Ignoring non-tradable items on the economic balance sheet

    Fix: List human capital and other items, then explain how they change the client's ability to take risk.

  • Skipping steps in calculations

    Fix: Write each step clearly. In the essay format a correct number earns full credit, but a clear working shows your path and helps you catch errors.

  • Writing long answers to command-word questions

    Fix: Answer exactly what the command word asks, and give only the number of responses requested, in the order given.

Last-day revision: Principles of Asset Allocation

  • The economic balance sheet includes human capital and other non-tradable items, not just financial assets.
  • Asset-only focuses on risk and return of assets; liability-relative focuses on funding liabilities; goals-based splits money into goal buckets.
  • Liability-relative allocation is the natural fit when there are clear, measurable liabilities.
  • Goals-based approaches assign different risk levels to different goals based on their importance.
  • Mean-variance optimization is sensitive to input estimates and can give concentrated portfolios.
  • Optimizer weights are only as good as the expected return, volatility and correlation inputs.
  • Risk budgeting allocates risk, not just capital, across asset classes or strategies.
  • Always check that a risk measure, such as standard deviation or value at risk, fits the client's real concern.
  • Strategic allocation is the long-term policy mix; tactical allocation is a short-term deviation from it.
  • Rebalancing keeps the portfolio near policy weights and has costs to weigh against drift.
  • Behavioral biases can lead to poor allocation choices, so the adviser should recognise and manage them.
  • In every answer, link the choice back to the client's objectives and constraints.

Principles 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.

Principles of Asset Allocation: frequently asked questions

What is the first thing to learn in Principles of Asset Allocation?

Start with the economic balance sheet and the three approaches. They set the framework for every later technique. If you know which approach suits which client, the tools make more sense.

How do I choose between asset-only, liability-relative and goals-based approaches?

Look at the client's facts. Clear, measurable liabilities point to liability-relative. Several goals of different importance point to goals-based. If neither applies, asset-only is typical. Always give a reason tied to the client.

Do I need to memorise formulas for this chapter?

You need the core calculations, such as portfolio expected return and variance, and basic risk measures. Practise them by hand so you can show the steps. Most marks, however, come from applying ideas to a client case.

Is there a penalty for guessing in item sets?

No. There is no penalty for wrong answers, so answer every question. Each multiple-choice item in an item set is worth 3 points.

How does this chapter connect to other topics?

It sets the strategic mix that portfolio construction, derivatives and risk management, and pathway topics build on. Understanding the client-first logic here helps you in those areas as well.