Asset allocation and diversification are key concepts in modern money management. They bring together traditional asset classes such as stocks, bonds, and cash, as well as alternative asset classes such as real estate, commodities, derivatives, and cryptocurrencies. By spreading risk across multiple investment types, investors can minimize downside, reduce volatility, and give themselves a greater chance of reaching their goals.
Not only are asset allocation and diversification useful for long-term investments, but they can also inform shorter-term tactical asset trading decisions. In this article, we will explore the importance of diversification and the principle of Modern Portfolio Theory, as well as providing some useful tips for implementing asset allocation and diversification in portfolio management today.
What is Asset Allocation and Diversification?
Asset allocation and diversification are two tactics that are used in order to minimize risk in a portfolio. While asset allocation outlines the percentage of capital that should be distributed between asset classes, diversification looks to individual assets within those asset classes that may not be correlated.
Asset allocation is an important concept because it enables investors to spread capital across different investment types in an effort to create a portfolio that is balanced and well-diversified. Asset allocation helps investors to balance their risk and returns, as the value of individual assets can change over time.
Diversification involves selecting assets within an asset class that generally do not move in the same direction when markets change. By combining uncorrelated assets, investors can increase returns while reducing risk compared to holding a single asset.
The main idea is that by combining assets from uncorrelated asset classes, the volatility of the portfolio can be reduced and the risk-adjusted performance should improve.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a mathematical framework developed by Nobel Laureate Harry Markowitz in 1952. It is a powerful collective concept that sums up the idea of asset allocation and diversification into one theory, where the aim is to make the most efficient portfolio possible based on achieving the highest returns for a given risk level.
MPT looks at how different assets move in different ways, and provides investors with the principle of spreading their capital across multiple assets in order to attain maximum returns with minimal risk.
Types of Asset Classes and Allocation Strategies
MPT states that asset classes should be categorized into two main types; traditional and alternative assets. Traditional assets refer to stocks, bonds, cash, and other more traditional methods of investing, while alternative assets are real estate, commodities, derivatives, insurance products, private equity and cryptocurrencies.
There are generally two main classes of asset allocation strategies which use the principles fulled by MPT: strategic asset allocation and tactical asset allocation. Strategic asset allocation is a passive approach which requires a portfolio to be rebalanced when necessary based on time horizon or risk profile changes. Tactical asset allocation takes a more active approach and involves making sector-led decisions in order to forward the portfolio towards higher returns.
Applying Asset Allocation and Diversification to a Portfolio
Let’s take the example of a portfolio that is allocating 40% of capital to stocks, 30% to bonds, 20% to cryptocurrencies, and 10% to cash. An asset allocation strategy may also dictate that 70% of the cryptocurrencies allocated are allocated to Bitcoin, 15% to large-cap projects, 10% to mid-cap projects, and 5% to small-caps.
By using an asset allocation and diversification strategy, investors can create portfolios with sufficient risk aversion, as well as giving themselves a greater chance of maximizing returns by selecting assets from across multiple markets.
Problems with Asset Allocation
Although asset allocation is an invaluable strategy for risk management, it is not without its flaws. Its effectiveness relies on an investor’s ability to disconnect from their own biases and make decisions beyond their emotional sphere.
It is also difficult to accurately determine an investor’s risk tolerance. After a certain period, the investor may realize that they wanted less or more risk than they initially anticipated.
Conclusion
Asset allocation and diversification are two essential principles that must be understood by investors. By diversifying across different asset classes, investors can minimize their downside risk, increase their portfolio efficiency, and, with the correct portfolio allocations and individual selections, can also maximize returns.
The cryptocurrency market is highly correlated with the price of Bitcoin, making diversification among crypto assets highly challenging. Solutions are emerging, providing investors with tools that allow them to pick the right crypto assets that have minimal correlations to Bitcoin.
Although asset allocation and diversification can work well in the right circumstances, it must be noted that applying these principles correctly requires a great deal of expertise and experience. Many investors prefer to work with regulated financial advisors in order to benefit from their insights and advice. Ultimately, the decision on what asset allocation strategies are right for you will depend on your individual goals and risk appetite.
