What Is Asset Allocation and Diversification?
Money is never without risk, and both investments and cash holdings are subject to loss or erosion due to inflation. However, an individual's investment goals can determine how much risk they are willing to take on. The concepts of asset allocation and diversification are critical in this determination and have been used in investment strategies for thousands of years. In this article, we will provide an overview of these concepts and how they relate to modern money management strategies.
What Is Asset Allocation and Diversification?
Asset allocation and diversification are both risk management strategies, but they differ slightly in meaning. Asset allocation refers to how an investment portfolio distributes capital among asset classes, while diversification describes the allocation of capital within those classes. The goal of these strategies is to maximize returns while minimizing risk by considering an investor's time horizon, risk tolerance, and economic conditions. Essentially, these strategies aim to avoid putting all of one's investments in a single asset class.
Combining non-correlated asset classes is the most effective way to build a balanced portfolio. By using both strategies, risk is distributed not only between different asset classes but also within them. Some financial experts believe that asset allocation may be more important than the choice of individual investments.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a mathematical model that formalizes investment principles. Harry Markowitz introduced it in a 1952 paper and was later awarded the Nobel Prize in Economics. The theory is based on the idea that different asset categories tend to move in different ways. When one asset class underperforms, another might perform well, balancing out losses. By combining assets from uncorrelated asset classes, portfolio volatility can be reduced, leading to better risk-adjusted performance. MPT assumes that rational investors will choose a portfolio with less risk when two portfolios offer the same returns. In summary, MPT recommends combining assets in a portfolio that are not correlated.
Asset allocation is an important aspect of investment strategy, and assets can be divided into traditional and alternative categories. Traditional assets include stocks, bonds, and cash, while alternative assets encompass commodities, derivatives, insurance products, private equity, and crypto assets.
Two major types of asset allocation strategies are Strategic Asset Allocation and Tactical Asset Allocation. The former is suited to passive investment styles, and the portfolio is rebalanced only if there is a change in the investor's time horizon or risk profile. The latter is more active and allows investors to concentrate on assets that are outperforming the market.
The main objective of asset allocation and diversification strategies is to maximize expected returns while minimizing potential risk. By combining assets from uncorrelated asset classes, the volatility of the portfolio can be reduced, and risk-adjusted performance can be improved. Diversification is effective when assets are not completely correlated, and it is not necessary for assets to be completely uncorrelated or inversely correlated for diversification to have a beneficial effect.
How to Use in the Portfolio
When designing a portfolio, it's important to consider the principles of asset allocation and diversification. For instance, an asset allocation strategy might suggest the following portfolio allocations:
- 40% invested in stocks
- 30% in bonds
- 20% in crypto assets
- 10% in cash
Within the crypto asset allocation, a diversification strategy might suggest the following allocations:
- 70% to Bitcoin
- 15% to large-caps
- 10% to mid-caps
- 5% to small-caps
Once established, the portfolio's performance should be monitored and reviewed regularly. If the allocations shift, the portfolio may need to be rebalanced by buying and selling assets to adjust back to the desired proportions. This generally involves selling top performers and buying underperformers. It's important to note that the selection of assets will depend on the chosen strategy and individual investment goals.
It's also important to consider the level of risk associated with the portfolio. As crypto assets are among the riskiest of asset classes, this particular portfolio may be considered very risky due to its large allocation to crypto assets. A more risk-averse investor may want to allocate more of the portfolio to less risky asset classes such as bonds.
Applying diversification strategies to a crypto asset portfolio may be challenging due to the high correlation between Bitcoin and other cryptocurrencies. This correlation makes it difficult to create a basket of uncorrelated assets. While some altcoins may show decreased correlation with Bitcoin from time to time, such strategies are not as consistently applicable as in traditional markets. Nonetheless, as the crypto asset market matures, it may become possible to use a more systematic approach to diversification in a crypto asset portfolio. However, the market has a long way to go until then.
Asset allocation strategies are a powerful technique for managing portfolios, but they may not be suitable for all investors. While devising an asset allocation strategy can be simple, implementation is crucial to its success. Investors who cannot overcome their biases may undermine the effectiveness of the portfolio. Another challenge is accurately estimating an investor's risk tolerance. Once the results come in, the investor may realize they wanted less or more risk than originally anticipated. Therefore, it's important for investors to regularly review and adjust their asset allocation strategy to meet their changing needs and goals.
For thousands of years, asset allocation and diversification have been critical in managing risk, and they remain the core concepts behind modern portfolio management strategies. The primary objective of asset allocation is to maximize expected returns while minimizing risk, and it can improve portfolio efficiency by distributing risk among asset classes. However, when it comes to crypto asset portfolios, it is important to approach asset allocation strategies with caution due to the highly correlated nature of the markets with Bitcoin.