Introduction
Where there is money, there is always risk. Any investment can suffer losses, and the value of a pure cash position will be gradually eroded by inflation. Although risk cannot be eliminated, it can be adjusted according to one's specific investment goals.
The concepts of asset allocation and diversification play a key role in determining these risk parameters. Even if you are new to investing, you probably have some idea of the principles behind them, after all, these principles are thousands of years old.
This article will provide an overview of the concepts of asset allocation and diversification and how they relate to modern money management strategies.
For more information on related topics, read Financial Risk Explained.
What is asset allocation and diversification?
“Asset allocation” and “diversification” are two terms that are often used interchangeably. However, they have slightly different meanings when it comes to risk management.
Asset allocation is used to describe a money management strategy, outlining how funds should be allocated across the various asset classes of a portfolio. Diversification, on the other hand, refers to different allocations of capital across various asset classes.
The primary goal of these strategies is to maximize expected returns while minimizing potential risk. Typically, this involves determining the investor's investment time horizon, risk tolerance, and sometimes overall economic conditions.
In short, the main idea of asset allocation and diversification strategies can be summed up as “don’t put all your eggs in one basket.” The most effective way to build a balanced portfolio is to combine non-correlated asset classes and assets.
The power of combining these two strategies is that it not only diversifies risk across different asset classes, but also diversifies risk within those asset classes.
Some financial experts even believe that determining an asset allocation strategy is more important than choosing an individual investment approach.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a framework that puts these principles into a formula through mathematical models. It was first proposed by Harry Markowitz in a 1952 paper for which he subsequently won the Nobel Prize in Economics.
The major asset classes tend to move differently. Under the same market conditions, some asset classes perform well while others perform poorly. Therefore, the main assumption of this theory is that the losses caused by the poor performance of one asset class can be compensated by other asset classes that perform well.
Modern portfolio theory (MPT) proposes that combining non-correlated asset classes together can reduce portfolio volatility. This can also improve risk-adjusted performance, that is, a portfolio with the same level of risk will achieve a higher return. The theory also assumes that if two portfolios have the same return, any rational investor will prefer the one with less risk.
In short, Modern Portfolio Theory (MPT) states that a portfolio is most efficient when it is comprised of non-correlated assets.
Types of asset classes and allocation strategies
In a typical asset allocation framework, asset classes can be categorized as follows:
Traditional assets – stocks, bonds and cash.
Alternative assets – real estate, commodities, derivatives, insurance products, private equity, and of course, crypto assets.
Asset allocation strategies are generally divided into two major types, both of which use the assumptions outlined in Modern Portfolio Theory (MPT): strategic and tactical asset allocation.
Strategic asset allocation is a more traditional approach to passive investing. A portfolio using this strategy is only rebalanced if the desired allocation changes according to the investor's investment horizon or risk profile.
Tactical asset allocation is more suitable for a more proactive investment style. Investors will concentrate their portfolios on assets that have outperformed the market. The assumption here is that if a certain industry outperforms in the market, this advantage will continue for a considerable period of time. Since this allocation concept is also based on the principles outlined by Modern Portfolio Theory (MPT), it can also have a certain degree of diversification.
It is worth noting that diversification does not necessarily require that assets have no correlation or negative correlation in order to achieve good returns. Asset allocation only requires that there is no complete correlation.
Applying asset allocation and diversification in a portfolio
Let’s look at how these principles work with the following portfolio example. A particular asset allocation strategy might determine that a portfolio should be allocated to different asset classes in the following proportions:
40% invested in stocks
30% investment in bonds
20% invested in cryptocurrency assets
10% investment cash
The diversification strategy can be reflected in investing 20% of cryptocurrency assets:
70% invested in Bitcoin
15% investment in large-cap tokens
10% investment in mid-cap tokens
5% investment in small-cap tokens
Once the allocation is determined, the performance of the portfolio can be monitored and reviewed regularly. If the allocation changes, rebalancing can be performed. That is, the portfolio is adjusted by buying and selling assets to restore the desired proportions. The general practice is to sell strong performing assets and buy weak performing assets. Of course, the choice of assets is entirely determined by the investment strategy and personal investment goals.
Cryptocurrency assets are one of the riskiest asset classes. Due to the large proportion of crypto assets, this portfolio is considered to be riskier. Investors who want to avoid risks may want to allocate more of their portfolio to less risky asset classes such as bonds.
For an in-depth study on the benefits of Bitcoin in a diversified portfolio, read Binance Research’s report: Portfolio Management Series #1: Exploring the Diversification Benefits of Bitcoin.
Diversification in Crypto Asset Portfolios
While the principles behind these methods are theoretically applicable to a portfolio of crypto assets, they should be taken with a grain of salt. Crypto markets are closely tied to the price action of Bitcoin. This makes the task of diversification somewhat puzzling — how is it possible to create a non-correlated portfolio among a series of highly correlated assets?
Sometimes, the performance of certain altcoins decouples from Bitcoin, allowing careful traders to take advantage of opportunities. However, these don’t usually work as consistently as similar strategies in traditional markets.
However, we can assume that when the market matures, a systematic diversification approach can be adopted in the cryptocurrency asset portfolio. At present, the market is undoubtedly still a long way from maturity.
Asset Allocation Issues
Although asset allocation strategy is a powerful technical tool, some asset allocation strategies may not be suitable for certain investors and portfolios.
Developing an investment plan is relatively simple, but the key to a good asset allocation strategy lies in its successful implementation. If investors cannot put aside their biases, the effectiveness of the portfolio will be greatly reduced.
Another potential problem is that it’s difficult to gauge an investor’s risk tolerance. Only after a period of time, when investment results begin to emerge, do investors realize they want to take less (or more) risk.
Summarize
Asset allocation and diversification are fundamental concepts in risk management that have been around for thousands of years. They are also one of the core concepts of modern portfolio management strategies.
The main purpose of designing an asset allocation strategy is to maximize expected returns while minimizing risk. Diversifying risk among different asset classes can improve the efficiency of the portfolio.
Since the market is highly correlated with Bitcoin, extreme caution should be exercised when applying asset allocation strategies to a crypto asset portfolio.
