the introduction
When it comes to money, there is always a risk. Any investment can result in a loss, while holding only cash will cause its value to erode over time due to inflation. While risk cannot be eliminated, it can be modified to align with each individual's investment objectives.
Asset distribution and diversification are two concepts that play a major role in determining risk parameters. Even if you are new to the world of investing, you probably know the principles behind asset allocation and diversification because they have been around for thousands of years.
This article will give you an overview of these concepts and their relationship to modern money management strategies.
If you want to read more about a similar topic, see the article explaining financial risks.
What is Asset Allocation and Distribution?
The terms asset allocation and diversification are often used interchangeably. But they refer to two slightly different aspects of risk management.
The term asset allocation may be used to describe a money management strategy that determines how capital is allocated among different asset classes in an investment portfolio, while diversification may describe the distribution of capital within these asset classes.
The main goal of these strategies is to maximize expected returns while minimizing potential risks. Typically, this includes determining the investment time frame, risk tolerance, and sometimes a study of general economic conditions.
Simply put, the main idea of asset allocation and diversification strategies is to not put all your eggs in one basket. Incorporating asset classes and combining uncorrelated assets is the most effective way to build a balanced investment portfolio.
What makes these two strategies powerful together is that the risks are not only distributed between different asset classes, but they are also distributed within these asset classes.
Some financial experts even believe that determining an asset allocation strategy may be more important than choosing the investments themselves.
Modern theory of the investment portfolio
Modern Portfolio Theory (MPT) is a framework that formulates these principles through a mathematical model. This theory was proposed in a research paper published by Harry Markowitz in 1952, for which he later won the Nobel Prize for Economics.
Prices of different asset classes move at different rates. Market conditions that ensure a certain class of assets perform well may make another class of assets perform poorly. The basic assumption is that if one asset class performs poorly, assets can be offset by the good performance of another.
Modern portfolio theory posits that pooling assets from uncorrelated asset classes reduces the volatility of the portfolio's value. This should also increase risk-adjusted performance, meaning that an investment portfolio with the same risk profile will achieve higher returns. The theory also assumes that if any two investment portfolios provide the same returns, any rational investor will prefer the portfolio with the lower risk.
Simply put, modern portfolio theory says that the most efficient investment occurs by combining uncorrelated assets in a portfolio.
Types of asset classes and allocation strategies
In a normal asset allocation framework, assets can be classified in the following way:
Traditional assets — stocks, bonds, and cash.
Alternative assets — real estate, commodities, derivatives, insurance products, private equity, and of course digital assets.
In general, there are two types of asset allocation strategies, both of which use the assumptions of modern portfolio theory: strategic asset allocation and tactical asset allocation.
Strategic asset allocation is a traditional method that suits a less active investment style. The investment portfolio based on this strategy is rebalanced only if the desired distributions change based on a change in the time frame or the investor's degree of risk tolerance.
Tactical asset allocation is more suitable for more active investment styles, as it allows investors to focus their portfolios on assets that perform better than the market. This strategy assumes that if a sector performs better than the market, it may continue to do so for a long period of time. Because this strategy is also based on the principles of modern portfolio theory, it allows for some degree of asset diversification.
It should be noted that assets do not have to be completely uncorrelated or inversely related for the benefit of diversification to appear. The only condition is that the assets are not completely interconnected.
Applying asset allocation and diversification in an investment portfolio
Let's consider these principles through an example of an investment portfolio. An asset allocation strategy may specify that the portfolio should have the following distribution among the different classes of assets:
Invest 40% in stocks
30% in bonds
20% in digital assets
10% in cash
A diversification strategy might dictate that of the 20% invested in digital assets:
70% should be allocated to Bitcoin
15% for high market capitalization digital assets
10% for digital currencies of medium market capitalization
5% for cryptocurrencies with low market capitalization
Once these distributions are implemented, the performance of the portfolios can be monitored and reviewed regularly. If the distributions change, it may be time to rebalance — which means buying and selling assets to readjust the portfolio to the desired ratios. This typically involves selling the highest-performing assets and buying the lowest-performing assets. The choice of these assets, of course, depends entirely on the strategy and goals of each individual investor.
Digital assets are among the riskiest asset classes, and this portfolio may be considered high risk because it has a large percentage allocated to digital assets. A less risk-tolerant investor may want to allocate a larger share of his portfolio to bonds – a much lower risk category.
If you would like to read an in-depth research report on the benefits of Bitcoin in a multi-asset portfolio, see this report from Binance Research: Portfolio Management Series#1- Exploring the Diversification Benefits of Buying Bitcoin.
Diversification within the digital currency portfolio
While these principles should apply to a digital asset investment portfolio in theory, they should be treated with caution. The digital currency market is closely linked to the price movements of Bitcoin. This makes asset diversification an irrational task – how can you create a basket of unrelated assets from a group of highly correlated assets?
Sometimes, the correlation of altcoins with Bitcoin may weaken, and careful traders can exploit this. But these times do not last in a way that can be applied compared to similar strategies in traditional markets.
But we can assume that once the cryptocurrency market matures, a more systematic approach will be able to be used to diversify investments in the digital asset portfolio. There is no doubt that the market has a long way to go before reaching this stage.
Asset allocation problems
There is no doubt that asset allocation is a powerful investment approach, but some asset allocation strategies may not be suitable for certain investors and investment portfolios.
Coming up with an investment plan may be simple, but implementation is the essence of a good asset allocation strategy. If an investor is unable to put aside his biases, the efficiency of his investment portfolio may suffer.
Another potential problem comes from the difficulty of assessing risk tolerance before investing. Once results begin to appear after a certain period, the investor may realize that he desires less (or perhaps more) degree of risk.
Concluding thoughts
Asset allocation and diversification are two basic risk management concepts that have been around for thousands of years. They are also among the basic concepts of modern investment portfolio management strategies.
The main goal of developing an asset allocation strategy is to maximize expected returns while minimizing risks, and distributing risks between different asset classes may increase the efficiency of the investment portfolio.
Since the markets are closely linked to Bitcoin, asset allocation strategies should be applied to digital asset portfolios with care and caution.
