Introduce

Money always comes with risks. Any investment can lose money, while holding cash as a store of value gradually erodes due to inflation. Although risk cannot be eliminated, it can be adjusted to suit an individual's specific investment goals.

Asset allocation and diversification are concepts that play an important role in determining these risk factors. Even if you're new to investing, you're probably familiar with the fundamentals because they've been around for thousands of years.

This article will provide an overview of these principles and their relevance to today's money management strategies.

If you want to read more about the same topic, check out the article Explaining Financial Risk.


What is asset allocation and diversification?

The terms asset allocation and diversification are often used interchangeably. However, they may refer to slightly different aspects of risk management activities.

Asset allocation can be used to describe a money management strategy, which outlines how capital is allocated across asset classes within a portfolio. Meanwhile, diversification can describe the allocation of capital across those asset classes.

The main goal of these strategies is to maximize expected returns while minimizing potential risks. Typically, this involves determining the investor's investment time frame, risk tolerance and sometimes considering broader economic conditions.

Simply put, the main idea behind asset allocation and diversification strategies is to not put all your eggs in one basket. Combining uncorrelated asset classes and assets is the most effective way to build a balanced portfolio.

What makes these two strategies so effective together is that risk is not only distributed across different asset classes but also within those asset classes.

Some financial experts even believe that determining an asset allocation strategy can be more important than choosing individual investments.


Modern portfolio theory

Modern portfolio theory (MPT) is a framework that formalizes these principles through a mathematical model. MPT was introduced in a paper published by Harry Markowitz in 1952, for which he later received the Nobel Prize in Economics.

Major asset categories have varying trends. Market conditions that help one particular asset class perform well can also cause another asset class to underperform. The key assumption is that if one asset class underperforms, losses can be offset by another asset class that is performing well.

MPT assumes that combining assets from uncorrelated asset classes can reduce portfolio volatility. This will also increase risk-adjusted performance, meaning portfolios with the same level of risk will deliver better returns. MPT also assumes that if two portfolios yield the same returns, any wise investor will prefer the less risky portfolio.

Simply put, MPT claims that combining uncorrelated assets in a portfolio is the most efficient way to go.


Asset types and allocation strategies

In a conventional asset allocation framework, asset classes can be classified as follows:

  • Traditional assets - stocks, bonds and cash.

  • Alternative assets - real estate, commodities, derivatives, insurance products, private equity funds and of course cryptocurrencies.

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

Strategic asset allocation is considered a traditional method, suited to a more passive investment style. Portfolios based on this strategy will tend to rebalance only when the desired allocation structure changes based on a change in the investor's time frame or risk tolerance.

Tactical asset allocation is more suited to an active investing style. This method allows investors to focus their investment portfolio on assets that are showing positive expectations in the market. This method makes the assumption that if a sector is showing positive expectations in the market, then that sector can continue to perform well over a long period of time. Because it is based on the principles outlined in the MPT, this method also allows for a degree of diversification.

It is worth noting that assets do not have to be completely uncorrelated or negatively correlated for diversification to have a beneficial effect. Just not completely correlated.


Apply asset allocation and diversification to your investment portfolio

We'll look at these principles through a specific investment portfolio. An asset allocation strategy might stipulate that the portfolio should have the following allocation structure across different asset classes:

  • 40% in stocks

  • 30% in bonds

  • 20% in cryptocurrency

  • 10% cash

A diversification strategy might stipulate that of the 20% invested in cryptocurrency:

  • 70% will be allocated to Bitcoin

  • 15% for large-cap coins

  • 10% for mid-cap coins

  • 5% for small-cap coins

After establishing an allocation structure, investors can regularly monitor and evaluate the performance of their investment portfolio. If the allocation structure changes, it may be time to rebalance - that is, buy and sell assets to adjust the portfolio back to the desired ratio. This often involves selling the best performing assets and buying less performing assets. Asset selection of course depends entirely on each individual's investment strategy and goals.

Cryptocurrencies are one of the riskiest assets. This portfolio can be considered very risky, given that the investor has invested a significant amount in crypto assets. A risk-averse investor would likely allocate more capital to bonds - a much less risky asset class.

If you want to read an in-depth whitepaper on the benefits of Bitcoin in a diversified multi-asset portfolio, check out this report from Binance Research: Portfolio Management Series#1- Discover the Benefits Benefits of diversifying assets with Bitcoin.


Diversify your cryptocurrency portfolio

While we should theoretically apply the principles behind these methods to cryptocurrency portfolios, this is only part of the story. The cryptocurrency market is closely correlated with Bitcoin price movements. This makes asset diversification an impossible task - how can we create a basket of uncorrelated assets from a basket of highly correlated assets?

From time to time, some altcoins may be less correlated with Bitcoin and traders who follow it closely can take advantage of that. However, these strategies often do not last in a way that can be applied consistently like similar strategies in traditional markets.

However, it can be assumed that once the market matures, a more systematic approach to asset diversification may become viable for cryptocurrency portfolios. The market certainly has a long way to go until then.


Issues with asset allocation

Although undeniably effective techniques, some asset allocation strategies may not be suitable for some investors and portfolios.

Setting a strategy can be relatively simple, but the key to a successful asset allocation strategy is implementation. If investors are unable to set aside biases, portfolio performance may suffer.

Another potential problem comes from the difficulty of estimating an investor's risk tolerance in advance. When results start coming in after a certain period of time, investors may realize they want less (or even more) risk.


summary

Asset allocation and diversification are fundamental concepts of risk management that have been around for thousands of years. This is also one of the core concepts behind modern portfolio management strategies.

The main purpose of setting an asset allocation strategy is to maximize expected returns while minimizing risk. Allocating risk across asset classes can help increase portfolio efficiency.

Because the market is highly correlated with Bitcoin, investors need to carefully apply an asset allocation strategy to their cryptocurrency portfolio.