Asset Allocation and Diversification Explained
Where there is money, there is always risk. Any investment can suffer a loss, and the value of a pure cash position will be subject to gradual erosion by inflation. While risk cannot be eliminated, it can be adjusted to suit an individual’s specific investment objectives.
The concepts of asset allocation and diversification play a key role in determining these risk parameters. Even if you are new to investing, you must have some idea of the principles behind them; after all, they have been around for thousands of years.
In this article, we will provide an overview of the concepts of asset allocation and diversification and how they relate to modern money management strategies.
What is asset allocation and diversification?
The terms “asset allocation” and “diversification” are often used interchangeably. However, they differ slightly in terms of risk management.
Asset allocation is used to describe a money management strategy that outlines how money should be allocated to the various asset classes in a portfolio. Diversification, on the other hand, refers to different capital allocations within various 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 horizon, risk tolerance, and sometimes overall economic conditions.
In short, the main idea behind asset allocation and diversification strategies can be summarized as “don’t put all your eggs in one basket”. The most effective way to build a balanced portfolio is to combine non-correlated asset classes and assets.
The power of combining these two strategies is that it not only diversifies risk across asset classes, but also within those asset classes.
Some financial experts even argue that determining an asset allocation strategy is more important than choosing an individual investment approach.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a framework that puts these principles into formulas through mathematical models. Harry Markowitz proposed this framework in a paper published in 1952, for which he was subsequently awarded the Nobel Prize in Economics.
The major asset classes tend to move differently. Certain asset classes perform well while others underperform in the same market conditions. The main assumption of this theory is therefore that losses caused by the underperformance of one asset class can be compensated by other asset classes that perform well.
Modern Portfolio Theory (MPT) proposes that combining non-correlated asset classes together can reduce portfolio volatility. This can also improve risk-adjusted performance, meaning that portfolios with the same level of risk will earn higher returns. The theory also assumes that if two portfolios have the same return, any reasonable investor will prefer the less risky portfolio.
In short, Modern Portfolio Theory (MPT) states that portfolios are most effective when allocated to non-correlated assets.
Types of Asset Classes and Allocation Strategies
In a typical asset allocation framework, asset classes can be categorized in the following ways:
Traditional assets — stocks, bonds and cash.
Alternative assets — real estate, commodities, derivatives, insurance products, private equity, and of course cryptocurrency assets.
Asset allocation strategies are typically categorized into two main types, both of which use the assumptions outlined in Modern Portfolio Theory (MPT), strategic and tactical asset allocation.
Strategic asset allocation is a traditional approach more suited to passive investing. Portfolios using this strategy are rebalanced only under one circumstance, when the desired allocation changes according to the investor’s investment horizon or risk profile.
Tactical asset allocation is better suited to a more proactive approach to investing. Investors will concentrate their portfolios on assets that are outperforming the market. The assumption here is that if a particular sector outperforms in the market, that advantage will continue to be maintained for a significant period of time. Since this allocation philosophy is also based on the principles outlined in Modern Portfolio Theory (MPT), it is equally possible to have a degree of diversification.
It is worth noting that diversification does not necessarily require assets to be completely uncorrelated, or negatively correlated, with each other in order to achieve good returns. Asset allocation need only be non-perfectly correlated.
Applying Asset Allocation and Diversification in Portfolios
Let’s see how these principles work with the following portfolio example. A certain asset allocation strategy might determine that a portfolio should be allocated to different asset classes in the following proportions:
40% invested in stocks
30% invested in bonds
20% invested in cryptocurrency assets
10% invested in cash
And a diversification strategy may be reflected among the 20% invested in cryptocurrency assets:
70% invested in Bitcoin
15% invested in large cap tokens
10% invested in mid-cap tokens
5% in small cap tokens
Once the allocation has been determined, the performance of the portfolio can be monitored and reviewed on a regular basis. If the allocation changes, it can be rebalanced. That is, the portfolio is adjusted by buying and selling assets to return to the desired ratio. The routine operation is to sell strongly performing assets and buy weakly performing assets. Of course, the choice of assets is entirely determined by the investment strategy and individual investment objectives.
Cryptocurrency assets are one of the riskiest major asset classes. With a sizable allocation to cryptocurrency assets, this portfolio is considered risky. Investors intent on hedging may want to allocate more of their portfolio to less risky asset classes such as bonds.
Diversification in a portfolio of cryptocurrency assets
In theory, while the principles behind these approaches apply equally to portfolios of cryptocurrency assets, they should still be taken with a grain of salt. The cryptocurrency market is closely tied to the price action of Bitcoin. This makes the task of asset diversification somewhat seem implausible — how is it possible to create a portfolio of non-correlated assets within a set of highly correlated assets?
Sometimes, the performance of certain torrents will decouple from Bitcoin, and careful traders will be able to capitalize on the opportunity. However, these usually won’t be as consistently applicable as similar strategies in traditional markets.
However, we can assume that when the market matures, it will be possible to systematically take a diversified approach in cryptocurrency asset portfolios as well. The current market is undoubtedly a long way from maturity.
Asset allocation issues
While asset allocation strategies are a powerful technical tool, some of them are not necessarily applicable to certain investors and portfolios.
Developing an investment plan is relatively simple, but the key to a good asset allocation strategy is its successful implementation. If investors are unable to set aside their biases, the effectiveness of their portfolios will be greatly diminished.
Another potential problem lies in the difficulty of predicting an investor’s risk tolerance. Only after a period of time, when the results of an investment begin to show, will investors realize that they want to take less (or more) risk.
Summing Up
Asset allocation and diversification are fundamental concepts of risk management that have been around for thousands of years. They are also among the core concepts of modern portfolio management strategies.
The main objective of designing an asset allocation strategy is to maximize expected returns while minimizing risk. Diversifying risk across different asset classes improves the efficiency of a portfolio.
Since the market is highly correlated to Bitcoin, extra caution should be taken when applying asset allocation strategies to cryptocurrency asset portfolios.
Comments
Post a Comment