CFA Level 3 Asset Allocation: notes and free practice
CFA Level 3 Asset Allocation sets a portfolio mix from objectives, constraints and capital-market expectations. Distinguish the long-term policy from tactical deviations and from trades that simply rebalance drift.
The key ideas, at a glance
Challenge the forecast
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
% estimated return
- Previous estimate
- 6
- Revised estimate
- 9
These are the case’s two estimates, not observed returns or a trend. Investigate valuation, earnings and regime assumptions behind the change.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Challenge the forecast | Use consistent horizons, currencies and economic assumptions. | A precise forecast can still be biased or based on an unrepresentative sample. |
| Choose the risk lens | Risk is relative to the goal, not just portfolio volatility. | Low asset volatility does not guarantee low funding risk. |
| Test the mix | Expected return is a weighted sum; risk also depends on covariance. | Optimizer output is highly sensitive to estimated returns and correlations. |
| Write a rebalancing rule | Restore the intended risk while respecting liquidity and costs. | Rebalancing restores risk; it does not guarantee higher returns. |
01Challenge the forecast
Use consistent horizons, currencies and economic assumptions.
Watch for: A precise forecast can still be biased or based on an unrepresentative sample.
02Choose the risk lens
Risk is relative to the goal, not just portfolio volatility.
Watch for: Low asset volatility does not guarantee low funding risk.
03Test the mix
Expected return is a weighted sum; risk also depends on covariance.
Watch for: Optimizer output is highly sensitive to estimated returns and correlations.
04Write a rebalancing rule
Restore the intended risk while respecting liquidity and costs.
Watch for: Rebalancing restores risk; it does not guarantee higher returns.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
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Common core, for all three pathways. Selected 2026 concepts, not complete curriculum coverage. Choose pathway-specific practice or check 2027 changes.
Put the method to work
One worked example, from facts to answer
Given
Equity return estimates rise from 6% to 9% after one unusually strong year.
Method
Test valuation, earnings and regime assumptions rather than extrapolating the latest return.
Answer and interpretation
Keep scenario ranges and investigate why the long-run forecast changed.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
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10 free Asset Allocation questions
Five multiple-choice questions and five written prompts. Self-review written answers against teaching rubrics, not official scoring keys. Short independent cases, not a mock or pass prediction.
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Completion is not an exam score. Written responses are self-reviewed, not automatically graded.
- Question 1 of 10Level III common-core sampleAsset AllocationMultiple choice
Case facts
An allocation has 50% equities with expected return 8%, 30% bonds at 4%, and 20% cash at 2%.
What is the portfolio’s expected return?
Answer and explanations
The weighted sum is 0.5 × 8% + 0.3 × 4% + 0.2 × 2% = 5.6%.
Review the method- A - correct: The weighted sum is 0.5 × 8% + 0.3 × 4% + 0.2 × 2% = 5.6%.
- B: An unweighted average would ignore the actual portfolio allocation.
- C: 6.0% overstates the return of the specified weighted mix.
- Question 2 of 10Level III common-core sampleAsset AllocationMultiple choice
Case facts
A pension plan has asset value 126 million and liability present value 120 million, measured on the same date.
What is the plan’s current funded ratio?
Answer and explanations
The funded ratio is assets divided by liabilities: 126/120 = 105.0%.
Review the method- A: 95.2% reverses the asset-to-liability ratio.
- B - correct: The funded ratio is assets divided by liabilities: 126/120 = 105.0%.
- C: Six million is the surplus amount, not the funded ratio percentage.
- Question 3 of 10Level III common-core sampleAsset AllocationMultiple choice
Case facts
A portfolio begins with 60 in equities and 40 in bonds. Equities gain 25%; bonds are unchanged. Target equity weight remains 60%. Ignore costs.
How much equity must be sold to return to the target weight?
Answer and explanations
Equities become 75 and total assets 115; target equities are 69, so sell 6 units.
Review the method- A: Selling the whole equity gain would restore the old amounts, not target weights on the new total.
- B: Three units would leave equities above the 60% target.
- C - correct: Equities become 75 and total assets 115; target equities are 69, so sell 6 units.
- Question 4 of 10Level III common-core sampleAsset AllocationMultiple choice
Case facts
A strategist calibrates long-run returns solely from a decade of falling yields and unusually strong bond price gains.
Which concern most directly challenges this forecast?
Answer and explanations
A period of falling yields may not represent the future regime, making simple extrapolation unreliable.
Review the method- A - correct: A period of falling yields may not represent the future regime, making simple extrapolation unreliable.
- B: A long sample can still reflect an unrepresentative economic regime.
- C: Forecasts remain possible, but they require assumptions beyond blindly extrapolating returns.
- Question 5 of 10Level III common-core sampleAsset AllocationMultiple choice
Case facts
For a two-asset portfolio, weights are 50/50, both volatilities are 10%, and correlation is zero.
What is the portfolio volatility, rounded to two decimals?
Answer and explanations
Variance is 0.5² × 0.1² + 0.5² × 0.1² = 0.005; its square root is 7.07%.
Review the method- A: A simple weighted average ignores the diversification effect of zero correlation.
- B - correct: Variance is 0.5² × 0.1² + 0.5² × 0.1² = 0.005; its square root is 7.07%.
- C: 5.00% is below the square root of the correctly combined variances.
- Question 6 of 10Level III common-core sampleAsset AllocationWritten response
Case facts
A foundation must pay a fixed, domestic-currency grant in nine months. Its remaining assets fund a long-horizon mission.
Recommend an allocation approach for the grant and justify it.
Model answer and self-review rubric
Separate the known grant from long-horizon assets and fund it with liquid, low-risk assets matched to the payment date and currency. The near-term liability should not depend on selling risky assets in a downturn.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 7 of 10Level III common-core sampleAsset AllocationWritten response
Case facts
A mean-variance optimizer puts 95% into one asset after its estimated return rises by 0.2 percentage points.
Recommend two checks before adopting this allocation.
Model answer and self-review rubric
Run sensitivity and scenario tests on expected returns, correlations and risk estimates. Add economically justified concentration and liquidity constraints, then assess whether the result meets client goals under less favorable assumptions.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 8 of 10Level III common-core sampleAsset AllocationWritten response
Case facts
A client’s main business and most financial assets are exposed to the same domestic cyclical industry.
Explain why the economic balance sheet may favor diversifying financial assets.
Model answer and self-review rubric
Business wealth and future labor income can fall alongside the industry holdings. Considering these nonportfolio exposures reveals concentration that the financial portfolio alone understates; diversified financial assets may reduce total economic risk.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 9 of 10Level III common-core sampleAsset AllocationWritten response
Case facts
A taxable portfolio exceeds its equity band, but selling immediately creates large capital gains. A cash contribution arrives next week.
Recommend an implementation choice and one limitation.
Model answer and self-review rubric
Consider directing the imminent cash contribution to underweight assets, reducing taxable sales. Check whether the contribution is sufficient and whether waiting leaves unacceptable risk outside the policy band.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 10 of 10Level III common-core sampleAsset AllocationWritten response
Case facts
A client requests a 7% expected return using 40% equities expected to earn 8% and 60% bonds expected to earn 3%.
Calculate the mix’s expected return and explain the implication for the objective.
Model answer and self-review rubric
Expected return is 0.40 × 8% + 0.60 × 3% = 5.0%. This is below the 7% objective; revisit spending, contributions, horizon or risk capacity rather than treating the requested return as a guaranteed forecast.
Review the methodTeaching checklist only. No official points or automated grade.
Four ideas to put to work
Find the method you need
Start with: Expected returns, covariance, asset weights and investor constraints.
METHOD 01
Challenge the forecast
Use consistent horizons, currencies and economic assumptions.
- Separate a long-run expectation from a short-term scenario.
- Check whether historical data represent the current regime.
- Stress the inputs that drive the allocation most.
Worked example
- Given
- Equity return estimates rise from 6% to 9% after one unusually strong year.
- Calculate / decide
- Test valuation, earnings and regime assumptions rather than extrapolating the latest return.
- Result
- Keep scenario ranges and investigate why the long-run forecast changed.
Watch for: A precise forecast can still be biased or based on an unrepresentative sample.
Practise this ideaMETHOD 02
Choose the risk lens
Risk is relative to the goal, not just portfolio volatility.
- Name the liability or goal and its horizon.
- Identify cash-flow dates, currency and inflation exposure.
- Choose an asset-only, liability-relative or goals-based lens.
Worked example
- Given
- Assets are 110 and liability present value is 100.
- Calculate / decide
- Funded ratio = 110/100; surplus = 110 - 100.
- Result
- 110% funded, with a surplus of 10; still test how both sides change.
Watch for: Low asset volatility does not guarantee low funding risk.
Practise this ideaMETHOD 03
Test the mix
Expected return is a weighted sum; risk also depends on covariance.
- Confirm that weights sum to one.
- Calculate expected return using consistent units.
- Stress correlations and impose realistic allocation constraints.
Worked example
- Given
- 60% equities at 7%; 40% bonds at 3%.
- Calculate / decide
- 0.60 × 7% + 0.40 × 3%.
- Result
- 5.4% expected return, not a promised outcome.
Watch for: Optimizer output is highly sensitive to estimated returns and correlations.
Practise this ideaMETHOD 04
Write a rebalancing rule
Restore the intended risk while respecting liquidity and costs.
- Compare current weights with policy bands.
- Use cash flows before unnecessary sales where practical.
- Evaluate taxes, costs and changes in client circumstances.
Worked example
- Given
- A 60/40 portfolio grows to 72 of equities and 40 of bonds.
- Calculate / decide
- Total = 112; policy equity amount = 0.60 × 112 = 67.2.
- Result
- Sell 4.8 of equities and buy bonds, ignoring costs and taxes.
Watch for: Rebalancing restores risk; it does not guarantee higher returns.
Practise this ideaQuestions about this topic
- How does a liability-relative objective differ from an asset-only objective?
- A liability-relative framework evaluates assets in relation to obligations and shortfall or surplus outcomes. An asset-only framework evaluates the asset portfolio’s risk and return without making the same liability-relative objective the central measure.
- Is rebalancing the same as a tactical allocation?
- No. Rebalancing restores an existing policy after drift. Tactical allocation deliberately deviates from policy to express a shorter-term view within the applicable risk and governance framework.
- Do exam weights prescribe study-hour allocations?
- No. They describe published exam emphasis. Your preparation also depends on baseline knowledge, remaining weaknesses, question formats and available time.
Apply the topic to a focused case
CFA Level 3 strategic vs tactical asset allocation
Strategic allocation establishes the long-term policy from objectives, constraints and capital-market assumptions. A change in a client’s liabilities or risk capacity can justify revisiting it. A recent return alone is not a complete reason to change policy. State what objective or assumption changed and how the proposed weights address it.
- Case facts
- A portfolio has 12 million of total assets, an unchanged 50% equity target and a current equity value of 6.6 million. Ignore costs and changes in total assets.
- Apply the method
- Target equity = 12 × 0.50 = 6 million. Current weight = 6.6 / 12 = 55%. Sell 0.6 million to return to the policy target.
- Interpretation
- Restoring 50% is rebalancing. Keeping 55% intentionally under a documented shorter-term view is a tactical overweight; changing the long-term target is a policy decision.
Independent teaching cases under the stated assumptions, rather than official questions or scoring keys.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 Level III common-core outline: Asset Allocation
- Official Level 3 format and curriculum
- 2026 CFA Level 3 portfolio management outline
- 2027 CFA Level 3 portfolio management outline
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