What is Asset Allocation and Diversification?
It must, first be noted that every investment strategy all has its ups and downs and its list of risks, depending on the predicted rate of returns. However, even the most stable currencies are still at risk of being devalued to nearly nothing in the future. Therefore, numerous financial advisors regularly suggest investors employ the risk management method of allocating and diversifying funds.
As the popular phrase has stated; “don’t put all your eggs in one basket,” if that certain basket were to take a tumble, all the eggs could potentially crack. The same goes for investment; by going “all-in” with only a certain asset, investors may be putting their funds at high risk. If the asset were to depreciate, the investor would be facing higher losses than those that had allocated their funds to numerous assets.
What is this strategy?
Asset allocation and Diversification take regard to dividing funds to numerous asset classes for long-term sustainable growth of expected returns in a matter of time wherein they can tolerate risks. This is the equivalent of putting one’s eggs into numerous baskets.
Modern Portfolio Theory (MPT)
The Modern Portfolio Theory (MPT) was a Nobel-winning initiative introduced by an American economist Harry Markowitz.
The theory briefly states that when investing, allocating funds to a variety of assets would help both assess and prevent the volatility of value, especially if the market conditions of each asset category are not highly correlated. Essentially, no matter how volatile a certain asset is, as long as a trader has also invested in other irrelevant assets as well, the portfolio’s risk and volatility would be adjusted and balanced out by the performance of the others.
What’s the difference between Asset allocation and Diversification?
Though the two are often interchangeable, asset allocation and diversification are two different domains.
Asset allocation is the management of expenditure between numerous types of assets to mitigate risk. The method requires investors to take numerous factors that directly hinder the market into account, such as economic conditions, government regulations and its effects. This approach is beneficial when assets are not in the same field of investment as a sense of balance can be provided, in accordance with the MPT.
An illustration of the usage is as follows: Investor A divides their expenditure costs into 5 parts and invests 30% in the stock market, 25% in cryptocurrency, 20% in property assets, 15% in bonds and another 10% kept in the form of cash. Whenever an asset of the 5 depreciates, the investor’s portfolio would still be secure, as the other four would balance out.
As for diversification, the term refers to the distribution of expenditure costs towards a single asset variation. Let’s say Investor A invested 25% of their funds into cryptocurrency. The funds can then be divided into four parts for four separate currencies; BTC 40%, ETH 30%, XRP 20% and XLM 10%. By diversifying their funds, the investor is now less likely to be at a loss when a single coin’s value depreciates.
The methods mentioned above are both means to diversify a portfolio to maximize the profit while mitigating risks.
However, the methods are not proven risk-free. Investors should still prepare their risk management strategies, invest with discipline and have in-depth research before investing in order to have the safest and most beneficial way possible.