Introduction
The topic of money is always connected with the topic of risks. All investments may be subject to losses, while cash investments will lose value due to inflation. Risk cannot be eliminated completely, but it can be reduced according to individual investment objectives.
Diversification and asset allocation are key concepts in determining risk parameters. Even if you are new to the investment market, you are probably familiar with the principles on which they are based, as these practices go back thousands of years.
This article provides an overview of these concepts and how they relate to modern asset management strategies.
If you want to learn more, check out the article on Financial Risk.
What is diversification and asset allocation?
The terms “diversification” and “asset allocation” are often used interchangeably. However, they relate to different aspects of risk management.
The term "Asset Allocation" can be used to describe a cash management strategy in which capital must be allocated among the asset classes of a portfolio of investments. “Diversification” can mean allocating capital across these asset classes.
The goal of these strategies is to maximize expected returns and reduce potential risk. These typically involve determining the investment horizon, risk appetite, and sometimes taking into account broader economic conditions.
Simply put, the core idea behind diversification and asset allocation comes down to the adage “Don’t put all your eggs in one basket.” Combining multiple asset classes and independent assets is an effective way to build a balanced portfolio.
The power of combining these two strategies is that risk is spread not only across different asset classes, but also within the asset classes themselves.
Some financial experts even believe that an asset allocation strategy is more important than individual investments.
Modern theory of investment portfolio
Modern Portfolio Theory (MPT) is a framework that formalizes the principles described above through a mathematical model. This theory was presented in a paper published by Harry Markowitz in 1952, for which he subsequently received the Nobel Prize in Economics.
Major asset categories tend to move differently. Market conditions that favor the growth of one asset class may cause losses in another class. The main hypothesis is that if one asset class moves lower, losses can be offset by returns in other asset classes.
Modern portfolio theory suggests that by combining assets from uncorrelated classes, portfolio volatility can be reduced. In addition, it should also improve the risk-adjusted investment performance, meaning a portfolio with the same level of risk will be more profitable. It also follows that if two portfolios have the same return, any rational investor will prefer the portfolio with less risk.
The theory essentially says that the most effective way is to combine assets in a portfolio that are not correlated with each other.
Types of asset classes and allocation strategies
According to a typical asset allocation system, asset classes can be divided into the following categories:
Traditional assets are stocks, bonds and cash.
Alternative assets – real estate, commodities, derivatives, insurance products, private equities and, of course, crypto assets.
Modern portfolio theory describes two types of asset allocation strategies: strategic and tactical.
Strategic asset allocation is considered a traditional approach, more suitable for a passive investment style. Portfolios based on this strategy will tend to rebalance if the desired asset allocation changes due to the investor's planning horizon or risk profile.
Tactical asset allocation is suitable for more active investing. It allows investors to concentrate assets in their portfolio that are outperforming the market. The assumption is that if a sector outperforms the market, it can continue to do so for a long time. Since tactical planning is equally based on the principles of portfolio theory, it also allows for some degree of diversification.
It is worth noting that for diversification, assets do not have to be completely independent of each other or completely correlated to have a positive effect. It is enough that they do not correlate completely.
Application of Asset Allocation and Diversification
Let's look at these principles using a portfolio as an example. According to the asset allocation strategy, the portfolio may have the following ratio of asset categories:
40% - shares
30% - bonds
20% - crypto assets
10% - cash
According to the diversification strategy, 20% of crypto assets can be distributed as follows:
70% - Bitcoin
15% - large-cap cryptocurrencies
10% - mid-cap cryptocurrencies
5% - small cap cryptocurrencies
Once the allocation is established, the portfolio will begin to require monitoring and regular analysis. If redistribution is necessary, it will take time to rebalance - buying and selling assets in order to establish the desired proportions in the portfolio. Typically this process involves selling the best-performing assets and buying underperforming ones. Of course, the choice of assets depends entirely on the strategy and individual investment goals.
Crypto assets are one of the most risk-prone asset classes. A portfolio that includes cryptocurrencies may be considered very risky. A more risk-averse investor may want to allocate a larger percentage of the portfolio to bonds, a much less risky asset class.
If you want to learn more about the benefits of Bitcoin in a diversified multi-asset portfolio, read the Binance Research report Portfolio Management#1- Exploring the Benefits of Diversification with Bitcoin.
Diversification of a portfolio of crypto assets
While the principles on which these methods are based are applicable to a crypto asset portfolio, they should be viewed with a critical eye. The cryptocurrency market is highly correlated with Bitcoin price movements. This makes diversification irrelevant. How can you create a currency basket of non-correlated assets from a basket of highly correlated assets?
Sometimes individual altcoins can show a decrease in correlation with Bitcoin, and careful traders take advantage of this. However, such situations are the exception and are not a sufficient basis for applying the same strategies as in traditional markets.
It can be assumed that as the market becomes more mature, a more systematic approach to diversification can be taken for a crypto asset portfolio. But the market still has a long way to go.
Asset Allocation Problems
Despite the undeniable advantages of this method, some asset allocation strategies may not be suitable for individual investors and portfolios.
Developing an action plan can be relatively simple, but the key to an effective asset allocation strategy is implementation. If an investor fails to set aside biases, the performance of the portfolio may be undermined.
Another potential problem is the difficulty of assessing the risk level of assets in advance. After a certain period, the investor may decide that a lower (or even greater) level of risk is desirable.
Summary
Diversification and asset allocation are fundamental concepts in risk management, concepts that have been around for thousands of years. They are also one of the key concepts of modern investment portfolio management strategies.
The main goal of an asset allocation strategy is to maximize expected returns while minimizing risk. Spreading risk across asset classes can improve portfolio performance.
Because the markets are heavily tied to Bitcoin, asset allocation strategies should be applied with caution to cryptocurrency portfolios.