There is always risk when it comes to money. An investment can lose money, but a cash-only account will see a gradual decline due to inflation. Although risk cannot be eliminated entirely, it can be modified to meet a person’s investment goals.
These concepts play an important role in defining the risk parameters. You’re likely familiar with the basic principles behind investing even if you are new to it. They’ve been around for thousands.
This article will give you an overview of these and how they relate with modern wealth management strategies.
What is asset diversification and asset allocation?
“Diversification” and “asset allocation”, are often used interchangeably. They can be used interchangeably to refer to different aspects of risk management.
Asset allocation is a way to describe a money management strategy. It describes how capital should be divided among different asset classes within an investment portfolio. Diversification can be used to describe how capital is distributed within these asset types.
These strategies are designed to maximize expected returns and minimize risk. This usually involves determining the time horizon for investors, their risk tolerance, and sometimes taking into account wider economic conditions.
The basic idea behind asset allocation and diversification strategies is to not put all your eggs into one basket. The best way to create a balanced portfolio is to combine asset classes with assets that are not closely related.
These strategies are powerful together because risk is not just distributed among asset classes but also within them.
Financial experts believe that an asset allocation strategy is more important than selecting individual investments.
Modern Portfolio Theory
Modern Portfolio Theory (MPT), a framework that formalizes these concepts through a mathematical model, is called Modern Portfolio Theory. Harry Markowitz published an article featuring him in 1952. He later received the Nobel Prize in Economics.
Major asset classes tend to move in different directions. Market conditions that favor one asset class’s performance can cause a decline in performance for another. It is a basic assumption that losses from one asset class can be offset with gains from another asset class that performs well.
MpT says that portfolio volatility can be decreased by combining assets of uncorrelated asset classes. MpT should also increase risk-adjusted performance. This means portfolios with similar levels of risk will produce higher returns. A rational investor will choose a portfolio that offers a lower return if they have access to two portfolios.
MPT simply means that unrelated assets can be combined into a portfolio.
Asset Class Types and Allocation Strategies
Asset classes can be broken down into the following categories in a typical asset allocation plan:
- Traditional assets Stocks, bonds, and cash
- Other assets: goods, derivatives and insurance products. Private capital is also available.
There are generally two types of asset allocation strategies. They both use the assumptions in the MPT.
The traditional strategy of strategic asset allocation is not suitable for passive investors. Portfolios built on this strategy are more likely to rebalance when the allocation is changed based on changes in the investor’s risk profile or time horizon.
Tactical asset allocation works better for active investment types. This allows investors to concentrate their portfolio on assets that outperform the market. If a sector performs well, it is expected that it will continue to outperform the market for a longer period of time. It is based equally on the MPT principles and allows for some diversification.
Diversification can have a positive impact on your assets. Only that they are not completely correlated is required.
Asset Allocation and Diversification in a Portfolio
Let’s take the portfolio as an example to illustrate these principles. A portfolio may be designed to have the following distributions among different asset classes.
- 40% of the capital was invested in shares
- Bonds up to 30%
- 20% in crypto assets
- 10% Cash
Diversification strategies may require that 20% of crypto assets be invested.
- 70% should go to Bitcoin
- 15% for large capital investment
- From 10% to mid-cap
- 5% for small-cap companies
Once the distribution has been established, it is possible to monitor and analyze the portfolio’s performance. If the allocation is changing, it might be time to rebalance. This means that you buy and sell assets in order to return the portfolio back to its original proportions. This involves buying and selling the best assets. The strategy chosen and the individual’s investment goals will determine which assets are selected.
Crypto assets are one of the most risky asset classes. The portfolio is considered extremely risky because a large portion of it is made up of crypto assets. An investor who is more cautious may choose to invest a larger portion to bonds or other less risky assets.
You can read a detailed study report by Binance Research on bitcoin’s benefits in a portfolio that includes multiple assets.
Diversification of the crypto asset portfolio
These principles should theoretically be applicable to crypto assets. However, it is best to treat them with suspicion. The price movements of bitcoin are highly correlated to the cryptocurrency market. Diversification is a difficult task because of this. How can you create a portfolio of uncorrelated assets out of a collection of highly correlated assets.
Some altcoins may have a lower correlation to bitcoins. This is something that attentive traders can exploit. They don’t last as long as traditional strategies.
It can be assumed, however, that a more systematic approach will become possible to diversify the portfolio of crypto assets as the market matures. The market still has a lot of work to do before it can be considered mature.
Questions about asset allocation
Although this is an unquestionably powerful strategy, there are some asset allocation strategies that may not be suitable for some investors or portfolios.
Although it can be easy to create a game plan, the most important step in implementing a sound asset allocation strategy is implementation. The portfolio’s performance can be hampered if the investor doesn’t get rid of his biases.
Another problem is the difficulty in preliminarily assessing investors risk tolerance. After a period of time, investors may begin to realize they want less risk or more.
Diversification and asset allocation are two fundamental concepts in risk management that have been around for thousands of years. They are also a core concept of modern portfolio management strategies.
A strategy for asset allocation is designed to maximize expected returns and minimize risk. A portfolio’s performance can be improved by spreading risk among different asset classes.
Markets are strongly correlated with Bitcoin, so asset allocation strategies for crypto asset portfolios should be used with caution.