Asset allocation and diversification: Lesson #8

This new 11-part series is designed for beginners who want to invest in cryptocurrencies but need more information before taking the plunge. Our goal is to provide clear and concise explanations of the fundamental concepts in the world of cryptocurrencies.

Over the following weeks, we’ll publish a weekly lesson covering one topic regarding investing in cryptocurrencies. Each lesson will take less than 5 minutes to read. At the end of the course, you will better understand how to invest in cryptocurrencies, what to invest in, and when is the right time to do it.

In the ever-evolving world of investments, risk is an unavoidable companion. While eliminating risk is impossible, adjusting it to align with your investment goals is achievable. This week, we will introduce you to the powerful duo of asset allocation and diversification – two significant concepts in determining your risk parameters.

🤞Asset Allocation & Diversification: A Dynamic Pair 

Asset allocation and diversification, though often used interchangeably, refer to slightly different aspects of risk management. Asset allocation is a money management strategy that outlines how capital should be distributed between asset classes in an investment portfolio. Diversification, on the other hand, refers to the allocation of capital within those asset classes.

The primary goal of these strategies is to maximize expected returns while minimizing potential risk. The age-old adage, “Don’t put all your eggs in one basket,” sums it up quite nicely. By combining asset classes and assets that aren’t correlated, you can build a balanced portfolio that spreads risk between different asset classes and within them.

Some financial experts even argue that determining the asset allocation strategy is more crucial than choosing individual investments.

📖Modern Portfolio Theory (MPT) 

The MPT, introduced by Harry Markowitz in 1952, is a mathematical model that formalizes the principles of asset allocation and diversification. MPT assumes that combining assets from uncorrelated asset classes can reduce your portfolio’s volatility, increase risk-adjusted performance, and create a more efficient investment strategy.

♟️Types of Asset Classes and Allocation Strategies 

Asset classes can be categorized as traditional (stocks, bonds, and cash) or alternative (real estate, commodities, derivatives, insurance products, private equity, and cryptoassets). Two major asset allocation strategies, Strategic Asset Allocation and Tactical Asset Allocation, are based on MPT’s assumptions.

• Strategic Asset Allocation: A traditional approach suitable for passive investment styles, where portfolios are rebalanced only when desired allocations shift due to changes in the investor’s time horizon or risk profile.

• Tactical Asset Allocation: More fitting for active investment styles, allowing investors to concentrate their portfolio on outperforming assets while maintaining diversification.

💱Applying Asset Allocation & Diversification to Your Portfolio 

Let’s consider a sample portfolio with the following allocations:

• 40% in stocks
• 30% in bonds
• 20% in cryptocurrencies
• 10% in cash

A diversification strategy might dictate that among the 20% invested in cryptocurrencies:

• 70% should be allocated to Bitcoin
• 15% to large market-cap coins
• 10% to mid market-cap coins
• 5% to small market cap coins

Monitor and review your portfolio regularly, and rebalance when allocations shift. This usually involves selling top performers and buying underperformers, depending on your strategy and investment goals.

Remember that cryptoassets are among the riskiest classes. More risk-averse investors may prefer allocating more to less risky asset classes.

📊Diversification Within a Crypto Portfolio 

Diversification in a crypto portfolio should be approached cautiously, as the cryptocurrency market is highly correlated with Bitcoin’s price movements. A more systematic approach to diversification within a crypto portfolio could become feasible as the market matures.

💡In short 

Asset allocation and diversification are time-tested concepts in risk management and the backbone of modern portfolio management strategies. You can optimize your portfolio for maximum returns and minimum risk by effectively distributing risk between asset classes.

As you consider your investments, remember to approach crypto portfolios cautiously due to their high correlation with Bitcoin.

Learn more: A Quick Guide to Building Your Cryptocurrency Portfolio

The views, thoughts, and opinions expressed in the text belong to the author and not necessarily to the author’s employer, organization, committee, or other group or individual.