What is Asset Allocation and Diversification?

Contents

• Entrance

• What is asset allocation and diversification?

• Modern Portfolio Theory

• Asset class and distribution strategy types

• Applying asset allocation and diversification to the portfolio

• Diversify your crypto asset portfolio

• Asset distribution issues

• latest ideas

Entrance

There is always risk when it comes to money. While any instrument can cause a loss, a cash-only position will slowly weaken due to inflation. Although risks cannot be completely eliminated, they can be adjusted to suit the individual's specific investment goals.

Asset allocation and diversification play a key role in determining these risk parameters. Because these concepts have been used for thousands of years, even if you're new to the world of investing, you're probably familiar with the underlying principles.

This article will provide a general summary of asset allocation and diversification and discuss their place in modern money management strategies.

If you want to learn more about a similar topic, read What are Financial Risks? You can read our article.

What is asset allocation and diversification?

Asset allocation and diversification are terms often used interchangeably. But they actually represent slightly different aspects of risk management.

Asset allocation is a money management strategy that outlines how capital should be distributed among asset classes within an investment portfolio. Diversification, on the other hand, may refer to the distribution of capital across these asset classes.

The primary goal of these strategies is to maximize expected returns while minimizing potential risks. Often this requires taking into account the investor's investment horizon, risk tolerance and sometimes wider economic conditions.

In its simplest form, the main idea behind asset allocation and diversification strategies can be summarized as not putting all your eggs in the same basket. The most effective way to create a balanced portfolio is to combine asset classes and non-correlated assets.

What makes these two strategies powerful when used together is that the risk is distributed not only across different asset classes, but also within these asset classes.

Some financial experts believe that determining the asset allocation strategy is even more important than the investment choices themselves.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a general framework that summarizes these principles through a mathematical model. It was introduced by Harry Markowitz in an article published in 1952. Markowitz later won the Nobel Prize in Economics for this work.

Major asset categories tend to move differently. Market conditions that cause one asset class to perform well may cause another asset class to underperform. The basic assumption is that if one asset class is underperforming, losses can be offset by a different asset class that is performing well.

MPT assumes that the volatility of the portfolio can be reduced by combining assets from non-correlated asset classes. This should also improve risk-adjusted performance, meaning that a portfolio with equal levels of risk will have a better return. However, it also assumes that if two portfolios offer equal returns, a rational investor will choose the less risky portfolio.

In short, MPT states that combining uncorrelated assets in a portfolio yields the most efficient result.

Asset class and distribution strategy types

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.

Broadly speaking, there are two primary types of asset allocation strategies, both of which use the assumptions outlined in MPT: Strategic Asset Allocation and Tactical Asset Allocation.

Strategic Asset Allocation is considered a traditional approach that suits more of a passive investing style. Portfolios using this strategy tend to rebalance only if desired allocations differ due to changes in the investor's time horizon or risk profile.

Tactical Asset Allocation is better suited for more active investment styles. It allows investors to focus their portfolios on assets that are performing well in the market. This strategy assumes that a sector that performs better in the market can continue to perform better over a long period of time. It also allows for a degree of diversification as it is based on the principles set out in MPT.

It is also important to note that assets do not have to be uncorrelated or inversely correlated for diversification to have beneficial effects. It is enough that the assets are not perfectly correlated with each other.

Applying asset allocation and diversification to the portfolio

Let's go over these principles with an example. An asset allocation strategy may specify that the portfolio should have the following distributions across different asset classes:

• 40% stock investment

• %30 bono

• 20% crypto assets

• %10 found

A diversification strategy might dictate that 20% invested in crypto assets be:

• 70% should be distributed to Bitcoin

• 15% for assets with high market value

• 10% market capitalization to mid-level assets

• 5% for assets with low market value

After the distribution is made, the performance of the portfolio can be monitored and evaluated regularly. If the distributions change, it may be time to rebalance, meaning assets can be bought and sold to bring the portfolio to the desired proportions. To do this, the best performers are usually sold and the poor performers are bought. Asset selection, of course, depends entirely on the strategy and individual investment goals.

Crypto assets are among the asset classes with the highest risk. This portfolio, a significant portion of which is allocated to crypto assets, can be considered a risky portfolio. For example, an investor who wants to take less risk may want to allocate a larger percentage of the portfolio to bonds, which are a much less risky asset class.

If you would like to read an in-depth report on the benefits of using Bitcoin in diversified multi-asset portfolios, you can read Binance Research's Portfolio Management Series#1- Benefits of diversifying with Bitcoin report.

Diversify your crypto asset portfolio

Although in theory the principles behind these methods also apply to crypto asset portfolios, caution should be exercised in this regard. The crypto asset market is highly correlated with the price movements of Bitcoin. This makes diversification pointless – how can one choose uncorrelated assets from among highly correlated assets?

Sometimes the correlation of some altcoins with Bitcoin decreases and careful investors benefit from this. However, this change does not last long enough to be applied consistently like similar strategies in traditional markets.

However, it can be assumed that a more systematic diversification approach will be available in a crypto asset portfolio once the market matures. The market has a long way to go until that time comes.

Asset distribution issues

While it is undoubtedly a very powerful technique, some asset allocation strategies may not be suitable for certain investors and portfolios.

Creating a good game plan can be easy, but the key to a good asset allocation strategy is execution. If the investor cannot put his prejudices aside, the effectiveness of the portfolio may suffer.

Another potential problem is that it is difficult to predict an investor's risk tolerance. After a certain period of time, when the results start coming in, the investor may realize that he wants less (or even more) risk.

Latest Ideas

Asset allocation and diversification are fundamental concepts of risk management that have existed for thousands of years. These are also among the fundamental concepts underlying modern portfolio management strategies.

The main goal of designing an asset allocation strategy is to maximize expected return while minimizing risks. Distributing risk across asset classes can increase the efficiency of the portfolio.

Asset allocation strategies should be applied cautiously to crypto asset portfolios as markets are highly correlated with Bitcoin.