Introduction

Money always carries risks. Any investment can incur losses, but holding cash alone will see its value eroded by inflation. While it cannot be eliminated, risk can be adjusted to align with each person's investment goals.

Asset allocation and diversification are concepts that play an important role in determining risk parameters. Even if you're new to investing, you're probably familiar with the basic principles because they've been around for thousands of years.

This article will give you insight into what and how asset allocation and diversification relate to modern financial management strategies.

If you want to read more about a similar topic, read Financial Risk Explained.


What is asset allocation and diversification?

Asset allocation and diversification are often considered the same terms. However, both have slightly different risk management aspects.

Asset allocation can be used to describe a money management strategy that outlines how capital is distributed among the different asset classes in an investment portfolio. On the other hand, diversification describes the allocation of capital within these asset classes.

The main goal of this strategy is to maximize expected returns while minimizing potential risks. Typically, this includes determining investment time horizons, risk tolerance, and consideration of broader economic conditions.

Simply put, the main concept behind asset allocation and diversification strategies is to not put all capital in one asset. Combining unrelated asset classes and assets is the most effective way to build a balanced portfolio.

What makes both strategies powerful is that risk is not only shared between different asset classes, but also between different assets within a class.

Some asset experts even believe that determining an asset allocation strategy may be more important than choosing the type of investment itself.


Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a framework that formalizes these principles through mathematical models. This theory was introduced in a paper published by Harry Markowitz in 1952, a paper that later led to his Nobel Prize in Economics.

Major asset categories tend to have different movements. Market conditions that make certain asset classes perform well may make other asset classes perform poorly. The key assumption is that if one asset class performs poorly, its losses can be offset by another asset class that performs well.

MPT assumes that combining assets from unrelated asset classes will reduce portfolio volatility. This will improve risk-adjusted performance. This means that a portfolio with the same amount of risk will produce better returns. MPT also assumes that if two portfolios offer the same returns, then a rational investor will choose the portfolio with less risk.

In short, MPT states that it is the most efficient way of combining assets into a portfolio that are not related to each other.


Types of asset classes and allocation strategies

In an asset allocation framework, asset classes are usually categorized as follows:

  • Traditional assets — stocks, bonds, and cash.

  • Alternative assets — real estate, commodities, derivatives, insurance products, private equity, and of course crypto assets.

In general, there are two main types of asset allocation strategies, both of which use a number of assumptions outlined in MPT: Strategic Asset Allocation and Tactical Asset Allocation.

Strategic Asset Allocation is considered a traditional approach that is more in line with a passive investment style. Portfolios based on this strategy will tend to undergo rebalancing only when the desired allocation changes based on changes in the investor's time horizon or risk profile.

Tactical Asset Allocation is better suited to a more active investment style. This strategy allows investors to focus their portfolio in assets that outperform the market. This strategy assumes that if a sector outperforms the market, that sector can continue to outperform over the long term. Because it is also based on the principles outlined in MPT, this strategy allows for diversification.

It should be noted that assets do not have to be completely uncorrelated or inversely correlated for diversification to be achieved. What is needed is a state where these assets are not completely correlated.


Implement asset allocation and diversification into the portfolio

Let's look at these principles through a portfolio example. A portfolio in an asset allocation strategy has the following allocation among different asset classes:

  • 40% stock investment

  • 30% bonds

  • 20% crypto assets

  • 10% cash

A diversification strategy might dictate that among 20% ​​of investments in crypto assets:

  • 70% should be allocated to Bitcoin

  • 15% to large cap cryptos

  • 10% to mid-cap crypto

  • 5% to small cap crypto

Once allocations are set, portfolio performance can be monitored and reviewed regularly. If allocations change, it may be time to rebalance. That is, buying and selling assets to readjust the portfolio to the desired proportions. This usually involves selling well-performing assets and purchasing underperforming assets. Of course, asset selection depends entirely on the individual's investment strategy and goals.

Crypto assets are one of the riskiest asset classes. This portfolio may be considered very risky, because there is a fairly large portion allocated to crypto assets. Investors who are more risk-averse should allocate a large portion of their portfolio to less risky asset classes, such as bonds.

If you want to read an in-depth research report on the benefits of Bitcoin in a diversified multi-asset portfolio, read this report by Binance Research: Portfolio Management Series#1- Exploring the benefits of diversification with Bitcoin.


Diversification within a crypto asset portfolio

While the principles behind these methods apply to crypto asset portfolios in theory, we should still exercise caution. The cryptocurrency market is closely linked to Bitcoin price movements. This makes diversification unreasonable. How can one derive a set of uncorrelated assets from a set of highly correlated assets?

Sometimes, certain altcoins can show a low correlation with Bitcoin. Traders who pay attention to this can take advantage of it. However, this usually cannot be implemented as consistently as similar strategies in traditional markets.

We can assume that once the market matures, a more systematic approach to diversification will be applicable in crypto asset portfolios. However, there is still a long way to go before this is achieved.


Problems in asset allocation

While this is a powerful technique, some asset allocation strategies may not be suitable for certain investors and portfolios.

Making a plan is easy, but the key to a good asset allocation strategy lies in implementation. If investors cannot set aside their biases, their portfolios will not be as effective as desired.

Another potential problem arises from the difficulty in estimating investors' risk tolerance. When returns start to show after a certain period, the investor may realize that he wants lower (or even higher) risk.


Closing

Asset allocation and diversification are basic risk management concepts that have been around for thousands of years. They are also the core concepts behind modern portfolio management strategies.

The main goal of developing an asset allocation strategy is to maximize expected returns while minimizing risk. Distributing risk between asset classes can improve portfolio efficiency.

Since the market is highly correlated with Bitcoin, asset allocation strategies should be applied with extreme caution to a portfolio of crypto assets.