Learn all about asset allocation from this article
When it comes to money, there is always risk. Any investment can result in a loss, while holding cash only will erode its value over time due to inflation. While we cannot eliminate or mitigate the risks in an investment portfolio, we can adjust them to align with each individual’s investment objectives.
Asset allocation and diversification are two concepts that play an important role in determining risk parameters. Even if you are new to the world of investing, you probably know the principles behind asset allocation and diversification because they have been around for thousands of years.
What is asset allocation?
The terms asset allocation and diversification are often used interchangeably. But they refer to two slightly different aspects of risk management.
We may use asset allocation to describe a money management strategy that specifies how capital is distributed among different asset classes in an investment portfolio. In turn, diversification may explain the distribution of wealth within these asset classes.
The main objective of these strategies is to maximize expected returns while minimizing potential risks. Typically this includes determining the investment time frame, risk tolerance, and sometimes an examination of general economic conditions.
Simply put, the main idea of asset allocation and diversification strategies is not to put all your eggs in one basket. Including asset classes and grouping unrelated assets is the most effective way to build a balanced investment portfolio. This enables you to get some of the benefits of a safe conservative investment.
What makes these two strategies so powerful is that risk is distributed among different asset classes. It is also distributed within these asset classes.
In fact, some financial experts believe that defining an asset allocation strategy may be more important than choosing the investments themselves.
Strategic Asset Allocation
- The expected rate of return for each investment category. By looking at the rates of return it achieved in the past in the long term, or by looking at specific indicators of its performance expectations.
- The rate of risk (or volatility) is expected for each investment class. This is done by looking at the volatility rates that have occurred in the past over the long term. It can also be by looking at certain indicators of its volatility forecast.
- The amount of correlation between different investment classes in price movements and performance.
- So how does mixing them together affect the portfolio’s risk profile as a whole?
- The amount of risk an investor is willing to take.
Types of Asset Allocation
In the normal framework of asset allocation, assets can be classified as:
- Conventional assets – stocks, bonds, cash.
- Alternative assets – real estate, commodities, financial derivatives, insurance products, private equity, and of course digital assets.
In general, there are two types of asset allocation strategies, and both use the assumptions of modern portfolio theory: strategic asset allocation and tactical asset allocation.
Strategic asset allocation is a traditional method that suits a less active investment style.
The investment portfolio is not rebalanced with this strategy unless the desired distributions change based on a change in the investor’s time scale or risk tolerance.
Tactical asset allocation is more suitable for more active investment methods. It allows investors to focus their portfolios on assets that are performing better than the market.
This strategy assumes that if the sector is performing better than the market, it may continue to do so for an extended period of time.
Since this strategy is also based on the principles of modern portfolio theory, it allows a certain degree of asset diversification.
It should be noted that assets do not have to be completely separate or inversely related for the benefit of diversification to appear. The only requirement is that the assets should not be fully linked.
The application of asset allocation and diversification in an investment portfolio
Let’s look at these principles through an example of an investment portfolio. An asset allocation strategy may specify that a portfolio should have the following distribution among different asset classes:
1. Invest 40% in stocks.
2 30% in bonds.
3.20% in digital assets.
4. 10% cash.
A diversification strategy might dictate that out of the 20% invested in digital assets:
1.70% should go to Bitcoin.
2.15% for digital assets with a high market capitalization.
3.10% for medium-sized cryptocurrencies.
4. 5% for cryptocurrencies with low market capitalization.
Once the assets are allocated, the investor can monitor and review the performance of the portfolio regularly. And if the distributions change, it may be time to rebalance – which means buying and selling assets to reset the portfolio to the desired proportions.
This usually involves selling the higher performing assets and buying the lower performing assets. Of course, the choice of these assets depends entirely on the strategy and goals of each individual investor.
How are the assets distributed within the cryptocurrency portfolio?
While the principles of asset allocation should apply to a portfolio investing in digital assets in theory, we should approach them with caution. The cryptocurrency market is closely related to Bitcoin price movements.
This makes asset diversification a illogical task – how can a series of unrelated assets emerge from a group of closely related assets?
Sometimes the correlation of altcoins with Bitcoin can weaken, and vigilant traders can take advantage of this. But these times do not last in a way that can be applied as similar strategies in traditional markets.
We can assume that once the cryptocurrency market matures. We can use a more systematic approach to diversify the investments in a digital asset portfolio. There is no doubt that the market has a long way to go before it reaches this point.
What are the asset allocation problems?
There is no doubt that asset allocation is a powerful investment vehicle. Some asset allocation strategies may not be suitable for some investors and investment portfolios.
Coming up with an investment plan can be simple. However, implementation is at the core of a good asset allocation strategy. If the investor is unable to put aside his biases, the efficiency of his investment portfolio decreases.
Another potential problem comes from the difficulty of assessing risk tolerance before investing. Once the results start to show after a certain period of time, the investor may realize that he wants to take less (or maybe more) risk.