Asset Allocation and Diversification Explained

Introduction

When it comes to money, there is always risk. Any investment can incur a loss, while a cash-only position will see value slowly eroded through inflation. While risk cannot be eliminated, it can be adjusted to be aligned with an individual’s particular investment goals.

Asset allocation and diversification are concepts that play a key role in determining these risk parameters. Even if you’re new to investing, you’re probably familiar with the principles behind them as they have been in existence for thousands of years. 

This article will give an overview of what they are and how they relate to modern money management strategies. 

If you’d like to read more about a similar subject, check out Financial Risk Explained. 

What is asset allocation and diversification?

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

Asset allocation may be used to describe a money management strategy that outlines how capital should be distributed between asset classes in an investment portfolio. Diversification, on the other hand, might describe the allocation of capital within those asset classes. 

The main objective of these strategies is to maximize the expected returns while minimizing the potential risk. Typically, this involves determining the investor’s investment time horizon, risk tolerance, and sometimes consideration of the 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 asset classes and assets that aren’t correlated is the most effective way to build a balanced portfolio.

What makes these two strategies powerful in combination is that risk isn’t only distributed between different asset classes, but also within those asset classes. 

Some financial experts even believe that determining the asset allocation strategy might be more important than the choice of individual investments themselves. 

Modern Portfolio Theory

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

Major asset categories tend to move differently. Market conditions that make a particular asset class perform well might make another asset class perform poorly. The main assumption is that if one asset class underperforms, the losses can be balanced out by another asset class that is performing well.  

MPT assumes that by combining assets from uncorrelated asset classes, the volatility of the portfolio can be reduced. This should also increase the risk-adjusted performance, meaning a portfolio with the same amount of risk will yield better returns. It also assumes that if two portfolios offer the same returns, any rational investor will prefer the portfolio with less risk. 

Simply put, MPT states that it is the most efficient to combine assets in a portfolio that aren’t correlated.

Types of asset classes and allocation strategies

Within a typical asset allocation framework, asset classes can be categorized in the following way: 

Traditional assets — stocks, bonds, and cash. 

Alternative assets — real estate, commodities, derivatives, insurance products, private equity, and of course, cryptoassets.

Generally, there are two major types of asset allocation strategies, both using the assumptions outlined in MPT: Strategic Asset Allocation and Tactical Asset Allocation. 

Strategic Asset Allocation is considered to be a traditional approach that is more suited to a passive investment style. Portfolios based on this strategy will tend to be rebalanced only if the desired allocations shift based on a change in the investor’s time horizon or risk profile. 

Tactical Asset Allocation is a better fit for more active investment styles. It allows investors to concentrate their portfolio on assets that are outperforming the market. It makes the assumption that if a sector is outperforming the market, it may continue to outperform it for an extended period of time. Since it is equally based on the principles outlined in MPT, it also allows for some degree of diversification.

It is worth noting that assets do not have to be completely uncorrelated or inversely correlated for diversification to have a beneficial effect. It only requires them not to be completely correlated. 

Applying asset allocation and diversification to a portfolio

Let’s consider these principles through an example portfolio. An asset allocation strategy may determine that the portfolio should have the following allocations between different asset classes:

40% invested in stocks

30% in bonds

20% in cryptoassets

10% in cash 

A diversification strategy may dictate that among the 20% invested in cryptoassets: 

70% should be allocated to Bitcoin

15% to large-caps

10% to mid-caps

5% to small-caps

Once the allocations are established, the performance of the portfolio may be monitored and reviewed regularly. If the allocations shift, it may be time to rebalance — meaning buying and selling assets to adjust the portfolio back to the desired proportions. This generally involves selling top performers and buying underperformers. The selection of assets is, of course, entirely dependent on the strategy and individual investment goals. 

Cryptoassets are among the riskiest of asset classes. This portfolio may be considered very risky, as it has a considerable portion allocated to cryptoassets. A more risk-averse investor may want to allocate more of the portfolio to, say, bonds – a much less risky asset class. 

If you’d like to read an in-depth research report on the benefits of Bitcoin in a diversified multi-asset portfolio, see this report by Binance Research: Portfolio Management Series #1 - Exploring the diversification benefits with Bitcoin.

Diversification within a cryptoasset portfolio

While the principles behind these methods should apply to a cryptoasset portfolio in theory, they should be taken with a grain of salt. The cryptocurrency market is highly correlated to the price movements of Bitcoin. This makes diversification an unreasonable task – how can one create a basket of uncorrelated assets from a basket of highly correlated assets?

At times, specific altcoins may show a decreased correlation with Bitcoin, and attentive traders can take advantage of that. However, these typically do not last in a manner that is as consistently applicable as similar strategies in traditional markets.  

The assumption can be made, however, that once the market matures, a more systematic approach to diversification could become feasible within a cryptoasset portfolio. The market undoubtedly has a long way to go until then.

Problems with asset allocation

While an undeniably powerful technique, some asset allocation strategies might not be suitable for certain investors and portfolios. 

Devising a game plan can be relatively straightforward, but the key to a good asset allocation strategy is implementation. If the investor is unable to put their biases aside, the effectiveness of the portfolio might be undermined. 

Another potential problem comes from the difficulty of estimating an investor’s risk tolerance beforehand. Once the results start coming in after a given period, the investor might realize they wanted less (or even more) risk. 

Closing thoughts

Asset allocation and diversification are fundamental concepts of risk management that have existed for thousands of years. They are also one of the core concepts behind modern portfolio management strategies. 

The main purpose of devising an asset allocation strategy is maximizing the expected returns while minimizing the risk. Distributing risk between asset classes may increase the efficiency of the portfolio.

As the markets are highly correlated with Bitcoin, asset allocation strategies should be applied to cryptoasset portfolios with cautiousness.