Introduction

Where there is money, there is always risk. It is possible to lose money on any investment, and the value of a pure cash position will suffer the gradual erosion of inflation. Although risk cannot be eliminated, it can be tailored to 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’re new to investing, you’re probably familiar with the principles behind it—after all, these principles are thousands of years old.

This article will provide an overview of the concepts of asset allocation and diversification and how they relate to modern money management strategies.

For more detailed information on related topics, please read "Financial Risks Detailed".

What is asset allocation and diversification?

"Asset allocation" and "diversification" are two terms that are often used interchangeably. However, the two have slightly different approaches to risk management.

Asset allocation is used to describe a money management strategy, outlining how funds should be allocated among the various asset classes in a portfolio. Diversification, on the other hand, refers to different allocations of capital across 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 philosophy of asset allocation and diversification strategies can be summarized as "Don't put all your eggs in the same basket." The most effective way to build a balanced portfolio is to combine non-correlated asset classes and assets together.

The power of these two strategies combined is that it not only spreads risk across different asset classes, but also spreads risk within those asset classes.

Some financial experts even believe that determining an asset allocation strategy is more important than choosing a personal investment method.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a mathematical Models put these principles into a framework of formulas. Harry Markowitz proposed this framework in a 1952 paper for which he later won the Nobel Prize in Economics.

The major asset classes tend to have different trends. Certain asset classes perform well while others underperform in the same market conditions. So the main assumption of this theory is that losses caused by poor performance 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) points out that it is most effective to allocate non-correlated assets in a portfolio.

Types of asset classes and allocation strategies

In a typical asset allocation framework , asset classes can be classified as follows:

• 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 usually divided into two major types, both of which use the assumptions outlined in Modern Portfolio Theory (MPT), namely strategic and tactical asset allocation. .

Strategic asset allocation is a traditional approach more suitable for passive investing. A portfolio using this strategy is only rebalanced if the desired allocation changes based on the investor's investment horizon or risk profile.

Tactical asset allocation is more suitable for a more proactive investment approach. Investors will concentrate their portfolios on assets that have outperformed the market. The assumption here is that if an industry outperforms a market, that advantage will persist for a significant period of time. Since this allocation philosophy is also based on principles outlined in Modern Portfolio Theory (MPT), it can also have a certain degree of diversification.

It is worth noting that diversification to achieve good returns does not necessarily require assets to be completely uncorrelated, or have negative correlations. Asset allocation only requires imperfect correlation.

Applying asset allocation and diversification in a portfolio

Let’s go through the following Portfolio Example to see how these principles work. An asset allocation strategy might determine that a portfolio should be allocated to different asset classes in the following proportions:

• 40% in stocks
• 30% invested in bonds
• 20% invested in cryptocurrency assets
• 10% invested in cash

The diversification strategy can be reflected in 20% of the investment in cryptocurrency assets:

• 70% invested in Bitcoin
• 15% invested in large-cap tokens
• 10% invested Small-cap tokens
• 5% investment in small-cap tokens

Once the allocation is determined, the investment portfolio can be monitored and reviewed regularly performance. If the configuration changes, it can be rebalanced. That is, adjusting the portfolio by buying and selling assets to return it to the desired proportions. The normal operation is to sell assets that are performing strongly and buy assets that are performing weakly. Of course, asset selection is entirely determined by investment strategy and personal investment goals.

Cryptocurrency assets are one of the riskiest asset classes. Due to the sizeable allocation to crypto assets, this portfolio is considered riskier. Investors looking to avoid risk may want to allocate more of their portfolio to less risky asset classes such as bonds.

For an in-depth study on Bitcoin’s role in a diversified asset portfolio, read Binance Research’s report: Portfolio Management Series# 1: Exploring the diversified advantages of Bitcoin”.

Diversification in a Cryptocurrency Asset Portfolio

Theoretically, although The principles behind these methods apply equally to a portfolio of crypto assets, but they should still be taken with a grain of salt. The cryptocurrency market is closely tied to Bitcoin’s price movements. This makes the task of asset diversification somewhat unreasonable - how is it possible to create an uncorrelated portfolio of assets within a range of highly correlated assets?

Occasionally, the performance of certain altcoins will decouple from Bitcoin, and careful traders can take advantage of the opportunity. However, these often do not hold up as consistently as similar strategies in traditional markets.  

However, we can assume that when the market matures, a systematic approach to diversification can also be adopted in cryptocurrency asset portfolios. The current market is undoubtedly still a long way from maturity.

Asset Allocation Problem

While asset allocation strategy is a powerful technique means, but some asset allocation strategies may not necessarily work for certain investors and portfolios.  

Making an investment plan is relatively simple, but the key to a good asset allocation strategy lies in its smooth implementation. If investors are unable to put aside their biases, the effectiveness of their portfolios will be compromised.  

Another potential problem is the difficulty in estimating investors' risk tolerance. Only over time, as the results of the investment begin to show, do investors realize they wish to take on less (or more) risk.  

Summary

Asset allocation and diversification are basic concepts of risk management , has existed for thousands of years. They are also one of the core concepts of modern portfolio management strategies.  

The main purpose of designing an asset allocation strategy is to maximize expected returns while minimizing risks. Spreading risk across different asset classes can improve the efficiency of an investment portfolio.

Because the market is highly correlated with Bitcoin, extreme caution should be exercised when applying asset allocation strategies to a cryptocurrency asset portfolio.