What Is Asset Allocation And Diversification?

Money always involves some degree of risk. Every investment carries the potential for losses, while maintaining a solely cash-based position may lose value over time due to inflation. Although it is impossible to eliminate risk entirely, it can be managed to align with one's investment objectives.

Two fundamental concepts in managing risk are asset allocation and diversification. These principles have been used for thousands of years and continue to play a vital role in determining risk in modern investment strategies. This article will provide an overview of these concepts and how they relate to money management approaches today.

Asset Allocation and Diversification

The terms asset allocation and diversification are frequently used interchangeably, although they encompass distinct aspects of risk management.

Asset allocation refers to a money management approach that determines how capital should be divided among various asset classes within an investment portfolio. On the other hand, diversification pertains to the allocation of capital within those asset classes, aiming to spread investments across different assets.

The primary goal of these strategies is to maximize expected returns while minimizing potential risks. This typically involves considering factors such as the investor's time horizon for investments, their risk tolerance, and sometimes the broader economic conditions.

Essentially, asset allocation and diversification strategies revolve around the idea of not placing all investments in a single entity. By combining asset classes and assets that are not strongly correlated, a well-balanced portfolio can be constructed, reducing overall risk. The power of these two strategies lies not only in distributing risk among different asset classes but also within those asset classes themselves. Some financial experts also argue that determining the asset allocation strategy holds greater importance than the selection of individual investments.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a framework that provides a formalized approach to these principles using a mathematical model. This theory was first introduced by Harry Markowitz in 1952, for which he was later awarded the Nobel Prize in Economics.

Different asset categories tend to move in distinct ways. Market conditions that favor one asset class may have a negative impact on another. The fundamental assumption of MPT is that if one asset class experiences underperformance or loss, it can be offset by another asset class that is performing well.

MPT assumes that by combining assets from uncorrelated asset classes, the overall volatility of a portfolio can be reduced. As a result, the risk-adjusted performance of the portfolio is expected to improve, meaning that a portfolio with the same level of risk should generate higher returns. Additionally, MPT assumes that if two portfolios offer the same level of returns, any rational investor would prefer the portfolio with lower risk.

In essence, MPT suggests that the most efficient approach is to combine assets in a portfolio that exhibit minimal correlation with each other.

Asset Classes and Allocation Strategies

In a typical asset allocation framework, asset classes can be classified into the following categories:

Traditional assets: This category includes stocks, bonds, and cash.

Alternative assets: This category includes real estate, commodities, derivatives, insurance products, private equity, and crypto assets.

Generally, there are two main types of asset allocation strategies that utilize the assumptions laid out in Modern Portfolio Theory: Strategic Asset Allocation and Tactical Asset Allocation.

Strategic Asset Allocation is a conventional approach that is well-suited for passive investment styles. Portfolios based on this strategy are typically rebalanced only when the desired allocations change, due to shifts in the investor's time horizon or risk profile.

Tactical Asset Allocation, on the other hand, is more suitable for active investment styles. It allows investors to focus their portfolio on assets that are outperforming the market. This strategy assumes that if a particular sector is currently outperforming the market, it may continue to do so for an extended period. While it also incorporates the principles outlined in MPT, it still allows for a certain degree of diversification.

It is important to note that assets do not need to be entirely uncorrelated or inversely correlated for diversification to have a positive impact. Diversification only necessitates that the assets are not fully correlated with each other.

Asset Allocation and Diversification in an Example Portfolio

Let's explore these principles with an example. An asset allocation strategy suggests that the portfolio should be allocated as follows across different asset classes:

40% invested in stocks
30% in bonds
20% in cryptoassets
10% in cash

Within the 20% allocated to cryptoassets, an example of a diversification strategy could be the following allocations:

70% to Bitcoin
15% to large-cap cryptocurrencies
10% to mid-cap cryptocurrencies
5% to small-cap cryptocurrencies

Once the allocations are established, it is important to regularly monitor and review the portfolio's performance. If the allocations deviate from the desired proportions, it may be necessary to rebalance the portfolio by buying and selling assets. This typically involves selling assets that have performed well and purchasing assets that have underperformed. The specific selection of assets depends on the chosen strategy and individual investment goals.

It's important to note that crypto assets are among the riskiest asset classes. Consequently, this portfolio may be considered high-risk due to its significant allocation to crypto assets. For investors with a lower risk tolerance, it might be advisable to allocate a larger portion of the portfolio to less risky asset classes, such as bonds.

Diversification within a Crypto Portfolio

The principles of diversification can be applied to a cryptoasset portfolio in theory, but it is crucial to approach them with caution. The crypto market is highly correlated with Bitcoin's price movements, making it challenging to achieve diversification. How can you create a portfolio of uncorrelated assets when the underlying assets themselves are highly correlated?

From time to time, certain altcoins may show reduced correlation with Bitcoin, and vigilant traders may be able to capitalize on these opportunities. However, these instances are typically short-lived and are not always consistently applicable, as is the case with similar strategies within traditional markets.

Nonetheless, it is reasonable to assume that as the crypto market matures, a more systematic approach to diversification may become viable within a cryptoasset portfolio. However, the market still has a long way to go before reaching that stage.

Challenges with Asset Allocation

While asset allocation is an undoubtedly powerful strategy, it may not be suitable for all investors and portfolios.

Creating a strategic plan for asset allocation can be relatively simple, but the crucial factor for a successful strategy lies in its implementation. If investors are unable to set aside their biases and adhere to the strategy, it can undermine the effectiveness of the portfolio.

Another challenge arises from the difficulty to accurately gauge an investor's risk tolerance in advance. As time progresses and results start to unfold, investors may realize that their desired level of risk differs from their initial estimation, either wanting less or even more risk than anticipated.

In conclusion, asset allocation and diversification are timeless principles of risk management that play a crucial role in modern portfolio management strategies. The primary objective of developing an asset allocation strategy is to optimize expected returns while mitigating risk. By distributing risk across different asset classes, the efficiency of one’s portfolio can be enhanced.

It is important to exercise caution when applying asset allocation strategies to cryptoasset portfolios, given the high correlation with Bitcoin in the markets. Adapting these strategies to the unique characteristics of the crypto market requires careful consideration and assessment.