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The Magic Behind Asset Allocation and Diversification

In the financial world, there is no way to make money without exposing oneself to risk. How significant that risk factor is will significantly depend on how the individual trader approaches the different markets. Eliminating all risk is never possible, but it is possible to negate specific potential side effects.

Two methods to take into account are asset allocation and diversification. Either option can significantly impact risk parameters, but traders may have a better chance at remaining in the green when combined. 

Despite their names, neither of these concepts are new or innovative. They apply to nearly all trading and risk management strategies on the market, regardless of being a novice or experienced trader.

The Purpose of Asset Allocation & Diversification

While these two terms may sound confusing at first, they are often interchangeable. That doesn’t make them the same, as they have a different impact on risk management. 

Traders often rely on asset allocation to create a balance for investing in multiple assets within a portfolio. It is usually advisable for investors to separate their portfolios into smaller pieces and rebalance the assets depending on the prevailing market circumstances. 

Diversification, on the other hand, pertains to how the overall investments into these assets are made. One can attribute more or less money to any of the assets in one’s portfolio at any given time. Shifting around the capital allocation can prove worthwhile, depending on the asset and overarching conditions. 

The Modern Portfolio Theory Framework

In the financial world, there are mathematical models for anything that comes to mind. The asset allocation and diversification concept are subject to one such model, introduced in 1952 by Harry Markowitz, who later received the Nobel Prize in Economics for this contribution. 

Anyone will acknowledge that different asset categories will move independently from one another. Market conditions can make a popular asset perform very well, whereas other assets note the opposite impact. One asset can underperform while other popular markets report solid upward momentum. This is one reason why balancing out a portfolio and shifting capital allocation around can prove beneficial at any given moment. 

The Modern Portfolio Theory model assumes that anyone can reduce portfolio volatility by combining assets from uncorrelated classes. Ultimately, users will increase their risk-adjusted performance and potentially note far better returns. Investors may show a risk appetite at certain times and become risk-averse during other periods. Achieving the highest returns with the lowest risk is the main objective for everyone. 

The main takeaway from this method is never to combine assets in a portfolio that correlate with one another. With so many markets and asset classes to choose from, that should not prove to be much of a challenge. 

Distinguishing The Asset Classes

Users who want to begin experimenting with an investment portfolio will need first to figure out the different asset classes. More often than not, there are two types of asset categories to explore. All kinds of assets in that category have some degree of correlation capable of influencing the price performance. 

The first asset category is traditional assets, which include stocks, bonds, and cash. It is a well-known fact that stocks and bonds often share the same market trend, either for better or worse. Users who want to diversify their portfolio will need to pick one of these three assets rather than all three to maximize their profit potential. 

The second main category is alternative assets, which spans many markets one may consider not-correlated at first. Real estate, crypto assets, and insurance products would typically not fit into the same category. However, they all are alternative investments that deviate from the “norm,” even though they can provide a much better performance and return over the traditional assets.

Which Asset Allocation Strategy?

For investors and speculators, there are two main asset allocation strategies to explore today. One can go for either the Strategic or the Tactical option, both of which have potential benefits and drawbacks. 

Strategic Asset Allocation – or SAA – is a traditional approach for those who prefer to remain somewhat passive about their investment strategy. Investors opting for this approach will only rebalance if their desired allocations shift depending on the investor’s risk profile or time-based expectations (i.e., long-term to short-term due to market volatility).

Tactical Asset Allocation, or TAA, is more suited to active investors who focus on assets outperforming the market. If a sector notes stronger growth than the overall market, that trend may continue for some time. It is also a viable way for those who want to introduce a degree of diversification to their portfolio at any given time. 

Diversification of assets will often have a beneficial effect on a portfolio, regardless of whether they are [inversely] correlated or uncorrelated.

How To Apply Asset Allocation And Diversification

Now that the theory is out of the way, it becomes essential to put everything into action. The best way to do so is by creating an example portfolio that spans a few different asset classes. For example, a combination of stocks, bonds, cash, and crypto assets is an overall investment portfolio in 2021. As stocks, bonds, and cash are correlated compared to crypto assets; it is essential to diversify the crypto assets as best as possible.

One way of doing so is by spreading them out across the different crypto segments, or going by market cap:

  • A hefty investment in Bitcoin (up to 60%)
  • Diversification into large-cap currencies (20%)
  • A slight risk in mid-caps (10%)
  • A big risk in small-cap currencies (10%)

Once this allocation is established, the investor will need to monitor the portfolio’s performance carefully. As these crypto assets are all volatile in nature, new opportunities will arise every so often. Moreover, active diversification and rebalancing may prove necessary when any of the four segments outlined above outperform the overall industry trend. Going big on underperformers can prove wise, but only if those projects have a long-term plan capable of elevating them to new heights.

As crypto assets remain very risky vehicles by default, setting up a cryptocurrency portfolio is not for those who prefer a passive approach. Instead, it is an active task to manage everything accordingly. It remains possible to keep diversifying into other assets as well, depending on personal preference. 

Active Diversification With Crypto Assets

Even though the demo portfolio outlined above may seem easy enough to diversify, there are always caveats to consider. As most crypto assets have a strong correlation to Bitcoin or Ethereum, diversification is a very challenging task. Creating a set of uncorrelated assets from a basket of significantly correlated assets seems impossible in theory.

In reality, however, there are times when alternative currencies – mid-caps and small-caps seemingly decouple from Bitcoin’s price momentum for a while. Attentive traders can use these periods to their advantage, although it is a matter of acting quickly. Opportunities like these usually do not remain available for very long, further emphasizing the need for active portfolio management.

This situation may change in the future once cryptocurrency becomes a more mature market. If and when that will happen will remain anyone’s guess. Without maturity, there is no systematic approach to diversification that will make a long-term difference or impact.

It’s Not A Foolproof Method

On paper, it sounds very interesting to any investor to actively allocate and balance their portfolio depending on market circumstances. Doing so in an active manner is a lot more challenging than people assume. Not everyone has the same demand and expectations regarding asset allocation, making several strategies invalid.

It is pertinent for all investors and speculators to derive their game plan ahead of time. That includes incorporating asset allocation and putting market biases aside, which may be tricky for many people. Failure to adhere to this rule will undermine the potential of one’s portfolio. It is not in anyone’s best interest to do so out of the gate, yet it is a common trap many novice traders will fall for. 

Moreover, it is nigh impossible to gauge one’s investment risk appetite accurately. Even though one can analyze historical market data to get an idea of its overall performance, experiencing it when one’s own money is on the line is a very different ball game. Investors will often adjust their risk appetite over time through asset allocation and diversification. 

Closing Thoughts

One cannot deny the power and potential impact of asset allocation and diversification. These methods have existed for thousands of years and still hold a lot of value in 2021 and beyond. Even so, they are not the easiest or most straightforward concepts to get acquainted with as a novice investor. Acknowledging the need for modern portfolio management strategies is a crucial first step, but putting the theory into practice is something else entirely. 

WHile everyone wants to minimize their investment risk and attempt to maximize the profit potential, it is not always possible to do so in a passive manner. Those serious about asset allocation and diversification will need to manage their portfolios actively – often daily – and shift capital around per the market conditions. Distributing the risk between different asset classes can help achieve better portfolio efficiency, although one must consider all options carefully. 

Particularly where crypto assets are concerned, the correlation between different assets differs from more traditional investments. As nearly everything correlates to Bitcoin first and foremost, it can be difficult to achieve true diversification. Always do thorough research on markets and invest with caution to prevent portfolios from collapsing. 

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