WhaleVest｜WhaleVest 100 Compass｜Asset Allocation and Diversification Techniques

Preface

When money is involved, there is always risk. Loss is possible on any investment, and cash-only positions will slowly lose value due to inflation. While risk cannot be eliminated, adjustments can be made to fit an individual's specific investment goals.

Asset allocation and diversification are concepts that play a key role in determining these risk parameters. Even those new to investing are likely familiar with the principles behind it, as these concepts have been around for thousands of years.

This article will outline what these concepts are and how they relate to modern money management strategies.

If you would like to read more about similar topics, please see the description of financial risks.

What is asset allocation and diversification?

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

Asset allocation can be used to describe a money management strategy, outlining how capital should be allocated among different asset classes in a portfolio. Diversification, on the other hand, might describe the allocation of capital among these asset classes.

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

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

The power of these two strategies combined is that risk is not only distributed across different asset classes, but also within those asset classes.

Some financial experts even believe that the determination of asset allocation strategy may be more important than the choice of personal investment itself.

modern portfolio theory

Modern Portfolio Theory (MPT) is a framework that formalizes these principles through a mathematical model. It was proposed by Harry Markowitz in a 1952 paper for which he later won the Nobel Prize in Economics.

Major asset classes tend to move differently. Market conditions that make one asset class perform well may cause another asset class to perform poorly. The main assumption is that if one asset class performs poorly, losses can be balanced by another asset class that performs well.

MPT assumes that portfolio volatility can be reduced by combining assets from uncorrelated asset classes. This will also improve risk-adjusted performance, meaning a portfolio with equal risk will generate better returns. It also assumes that if two portfolios offer the same return, any rational investor would choose the less risky portfolio.

Simply put, MPT states that it is most efficient to combine uncorrelated assets in a portfolio.

Asset Classes and Types of Allocation Strategies

In a typical 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 and, of course, cryptoassets.

Generally speaking, there are two main types of asset allocation strategies that use the assumptions outlined in MPT: strategic asset allocation and tactical asset allocation.

Strategic asset allocation is considered a traditional approach and is more suitable for passive investing styles. Portfolios based on this strategy tend to rebalance required allocations only when an investor's time horizon or risk profile changes.

Tactical asset allocation is better suited for a more active investing style. It allows investors to focus their portfolios on assets that outperform the market. The assumption is that if an industry outperforms the market, it is likely to continue to outperform the market over an extended period of time.

A certain degree of pluralism is also allowed as it is also based on the principles outlined in MPT.

It is important to note that assets do not have to be completely uncorrelated or inversely correlated for diversification to have a beneficial effect. It only requires that the assets are not perfectly correlated.

Apply asset allocation and diversification to your portfolio

Let’s look at these principles through an example portfolio. An asset allocation strategy can determine how a portfolio should be divided among different asset classes:

40% invested in stocks 30% invested in bonds 20% invested in crypto assets 10% in cash

A diversification strategy might provide that of the 20% invested in crypto assets:

70% should be allocated to Bitcoin 15% to large caps 10% to mid caps 5% to small caps

Once allocations are determined, the performance of the portfolio can be monitored and reviewed regularly. If allocations change, it may be time to rebalance — buying and selling assets to adjust the portfolio to the ideal proportions. This typically involves selling stocks that are performing best and buying stocks that are underperforming.

Of course, asset selection depends entirely on strategy and personal investment goals.

Cryptoassets are one of the riskiest asset classes. This portfolio may be considered very risky as there is a significant portion allocated to crypto assets. More risk-averse investors may want to allocate more of their portfolio to, say, bonds, a much lower-risk asset class.

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