Crypto 101 Ep 2: Asset Allocation And Diversification Explained
When it comes to money, there is always an associated risk. Any investment can incur loss, while a cash-only position will likely see value slowly eroded through inflation. While risks cannot be eliminated, they can be minimized by being adjusted and aligned with your investment goals.
Asset allocation and diversification are key concepts that play an important role in determining these risk parameters. Even if you’re new to investing, you’re probably familiar with the principles behind the two concepts, as they have been in existence for thousands of years.
This article will give an overview of what asset allocation and diversification are and how they relate to modern money management strategies.
What are Asset Allocation and Diversification?
Diversification and asset allocation are terms that are frequently used interchangeably. They might, however, refer to a few slight differences in risk management.
A money management technique that specifies how capital should be allocated across different asset classes in an investment portfolio is known as asset allocation. On the other hand, diversification is the distribution of capital among those asset classes.
These techniques' primary goal is to maximize projected profits while lowering potential risk. This often entails figuring out the investor's investing time horizon, some risk tolerance, and occasionally taking into account broader economic factors.
The fundamental principle of asset allocation and diversification strategies is to avoid placing all of your financial eggs in one basket. The most efficient strategy to create a balanced portfolio is to combine asset classes.
What makes these two strategies effective together is that risk isn’t only distributed between different asset classes, but also within those asset classes. Some financial experts even believe that determining the asset allocation strategy might be more important than the choice of assets to invest in themselves.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a framework that formalizes these two principles through a mathematical model. It was introduced in a paper published in 1952 by Harry Markowitz. For his Theory, he later received the Nobel Prize in Economics.
Major asset categories tend to move differently. Market conditions that make a particular asset class perform well might make another type of asset perform poorly. The ideological backbone of the Modern Portfolio Theory is that instead of relying on one asset, you can spread the risk amongst multiple assets.
MPT assumes that the risk to your portfolio can be reduced by spreading risk with distinct assets that aren’t likely to influence each other. This reduction of risk in turn increases the risk-adjusted performance, meaning a portfolio with the same amount of risk will yield better returns. It also predicts that if two portfolios offer the same returns, any rational investor will prefer the portfolio with less risk.
Simply put, MPT states that “it is most efficient to combine assets in a portfolio that aren’t correlated”.
You can learn more about the modern portfolio theory here.
Types of Asset Classes and Allocation Strategies
Within the typical asset allocation framework, asset classes can be categorized by the following:
- Traditional assets — bonds, stocks, and cash.
- Alternative assets — real estate, derivatives, commodities, insurance products, private equity, and of course, crypto assets.
Strategic asset allocation and Tactical asset allocation are the two main categories of asset allocation methods, both of which rely on the premises established in MPT.
Strategic Asset Allocation is seen as a conventional strategy that works well with a passive investment technique. Portfolios based on a strategy tend to be rebalanced only when the investor's time horizon or risk tolerance causes the targeted allocations to alter.
More aggressive investment styles are better suited to tactical asset allocation. Investors can focus their portfolios on assets that outperform the market. It is based on the idea that if a sector outperforms the market, it might do so for an extended period.
It permits some degree of diversification because it is equally founded on the MPT principles.
It is important to remember that diversification can be advantageous even if assets are not related or if they are inversely related. It only requires that they aren't perfectly connected.
Applying Asset Allocation and diversification to a portfolio
Let’s consider these principles through a sample portfolio. An asset allocation strategy may determine that this portfolio should have the following allocations between different asset classes:
- 50% invested in stocks
- 25% in bonds
- 20% in crypto assets
- 5% in cash
A diversification strategy may dictate that among the 20% invested in crypto assets:
- 60% should be allocated to Bitcoin
- 20% to large-caps
- 10% to mid-caps
- 10% to small-caps
Once the allocations are established, the performance of the portfolio could be monitored and reviewed regularly. If the allocations are altered, it may be time to rebalance — meaning it may be time to buy and sell assets to adjust the portfolio back to the desired proportions. This usually involves selling top performers and buying underperformers. The selection of assets is, of course, entirely dependent on the individual’s investment goals and the strategies adopted to reach these goals.
Cryptoassets are some of the riskiest of asset classes. This portfolio may be considered very risky, as it has the lion's share allocated to crypto assets. A more risk-averse investor may want to allocate more of the portfolio to, say, stocks or bonds – much less risky asset class.
Diversification Within a Crypto Asset Portfolio
Theoretically, these approaches should work for a portfolio of crypto assets, but you should exercise caution when using them. The cryptocurrency market is highly correlated to the price movements of Bitcoin. This makes diversification unfeasible because how can you possibly turn a basket of highly correlated assets into a basket of uncorrelated assets?
Theoretically, these approaches should work for a portfolio of crypto assets, but caution should be exercised when using them. The price changes of Bitcoin have a strong correlation with the cryptocurrency market. This makes diversification unfeasible because it is impossible to turn a basket of highly correlated assets into a basket of uncorrelated assets.
Conscious traders can profit when some cryptocurrencies exhibit a decreased correlation with Bitcoin at certain moments. These, however, frequently do not hold up as consistently as similar strategies in traditional markets.
If, however, you still wish to pursue this further then you can read more about it here.
Problems with asset allocation
While an undeniably powerful technique, some asset allocation strategies may not be suitable for certain investors and portfolios.
Devising a game plan can be straightforward, but the key to a good asset allocation strategy is implementation. If you are unable to put your biases aside, the effectiveness of the portfolio might be undermined.
Another potential problem comes from the difficulty of estimating your risk tolerance beforehand. Once the results start coming in after a given period, you might realize that you wanted less (or even more) risk.
Asset allocation and diversification are fundamental concepts of risk management that have existed for ages. They are also one of the core concepts behind modern portfolio management techniques.
The main purpose of devising an asset allocation strategy is to maximize the expected returns while minimizing the risk. Distributing risk between asset classes will undoubtedly increase the efficiency of the portfolio.