As an Investors, it's possible to utilize multiple investment opportunities that don't correlate with one another to generate a favourable result. For example, we expect that over time investments in stocks will grow in value gradually, whilst still experiencing temporary fluctuations in the markets performance. To mitigate these temporary losses, a tried and tested management strategy is the diversification of your investments. This doesn't only mean diversification within one asset class, but across multiple asset classes, in order to maximize your returns while minimizing your exposure to risk.
What is asset allocation and Diversification?
Asset allocation concerns the allocation of your investment capital into different asset classes, for example an asset allocation strategy may dictate that you have 20% invested in Crypto, 30% in Stocks, 40% in real estate and 10% in Bonds. This shows how the division and allocation of your capital amongst asset classes can produce varying levels of exposure to risk as some asset classes are inherently more volatile and risky then others.
Furthermore, diversification refers to how the capital is allocated within the asset classes chosen as a part of your asset allocation strategy. For example, within the Crypto portion of your portfolio, you may choose to allocate 70% of your portfolio toward large-cap Crypto's Such as Bitcoin, Ethereum, Polkadot and XRP and then you may choose to allocate the other 30% to lower-market cap assets that present more volatility such as Ampleforth, Digibyte and Ocean Protocol. See the below attached portfolio for an example of this diversified Portfolio.
Diversification involves distributing your capital allocated for a particular asset class between the assets available in said asset class, which in turn reduces the exposure to risk as apart of your Asset Allocation strategy.
Through the use of Crypto you can expose yourself to investments in other asset classes such as foreign currency and exposure to commodities. A fair few of the assets we list have a value that is pinned to the underlying value of another asset. For example, each PAX Gold (PAXG) token's value is backed by one fine troy ounce (t oz) of a 400 oz London Good Delivery gold bar, stored in Brink’s vaults. Asset's like this can be incorporated into your method of diversification to expose your portfolio's performance to the use of Commodities through Crypto.
Asset allocation is essentially the basic "not putting all of your eggs in one basket" strategy as it allows you to divide your capital amongst multiple opportunities in an attempt mitigate risk and maximize gains. The mixture of these concepts makes for a strong investment strategy as the exposure to risk isn't only distributed between asset classes but is also distributed amongst the chosen asset classes.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) utilizes these concepts, it is a theory explaining how risk-averse investors can design a portfolio that mitigates exposure to risk for a given level of expected return. Harry Markowtiz, famed economist who received the Noel Prize for MPT, designed this theory and published it in the Journal of Finance in 1952.
Modern Portfolio Theory states that an investment's risk and return characteristics cannot be reviewed alone, but should be reviewed given how the investment affect the portfolio's total risk and return. It demonstrates that investors can design a portfolio of multiple different assets that will maximize the growth and return while mitigating risk.
Each major asset class can tend to move differently and a performance or market circumstances that yield an advantageous result in one asset class, may be a disastrous result in another. When utilizing MPT, the assumption is that the underperformance of an investment in one asset class can be mitigated through the performance of another, thus the need for asset allocation and diversification.
The foundation of MPT is built on combining assets from uncorrelated asset classes, that way the volatility and risk of the portfolio can be reduced. This assumes that when offered two portfolios with the same potential returns, any rational investor would choose the portfolio with less risk and that you can increase the risk-adjusted performance of the portfolio, meaning a portfolio the same risk can yield better returns.
Diversifying within a Crypto Portfolio
As the Cryptocurrency market is still new, these concepts should be applied carefully when investing in Crypto. The cryptocurrency market performance tends to follow the performance of Bitcoin. However, the movement of certain Altcoins can be interesting to follow as they don't necessarily follow the performance and movements BTC. Often times, Altcoins can perform quite differently to the current performance of BTC at times and as such can be utilized very well by sharp investors.
These temporary decreased correlations however are typically short lasted and as such, appropriate risk management strategies are important as well when dealing with any investment class. Please click here for more information on risk management strategies.
However, given that the Cryptocurrency market is still young, it is likely that once the asset class continues to develop and mature more, that more structured approaches to diversification within the asset class will develop.
Asset Allocation Issues
The key to any good investment strategy is to be objective when it comes to your applying your strategy. When you become too invested and bias with the implementation of the strategy, it means that the investment can fall apart and the efficacy of the strategy can be compromised.
Additionally, it is important to ensure that you have assessed what risk tolerance you are willing to accept when implementing your strategy. Once your strategy starts underperforming, you may realize that you wanted less exposure to risk. As such, it is important to realize what level of risk you are willing to expose your portfolio to and that you adjust your investment strategy accordingly.
Asset allocation is an important principle to apply in any investment strategy as it allows you to construct a portfolio of investments between asset classes that exposes you to a minimal measure of risk while maximizing the potential for profits. Furthermore, when applied in conjunction with an appropriate diversification strategy between said asset classes, this means that you can construct a well defined portfolio of investments that allows you to reduce your exposure to risk within each asset class. Selecting different forms of assets within these classes allows you too delegate your funds between investments with varying degrees of risk/reward ratios, for example a mixture of lower and higher market cap Crypto's, to improve your overall profit and maximize the performance of your portfolio.
The content provided is informative in nature and provided for educational and entertainment purposes only and is not and should not be construed as professional financial, investment, or legal advice. Application of information or trades placed are taken at your own risk based on your own Due Diligence.
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