Modern Portfolio Theory (MPT) is a mathematical framework introduced by Harry Markowitz in 1952, which posits that major asset categories tend to move differently, and that if one asset class underperforms, losses can be balanced by another. MPT assumes that combining assets from uncorrelated asset classes can reduce portfolio volatility and increase risk-adjusted performance. It also suggests that rational investors will prefer portfolios with less risk if they offer the same returns. In essence, MPT suggests that combining assets in a portfolio that aren't correlated is the most efficient approach.

Asset classes can be classified within a typical asset allocation framework in the following manner:

• Traditional assets — stocks, bonds, and cash.

• Alternative assets — real estate, commodities, derivatives, insurance products, private equity, and of course, cryptoassets.

Asset allocation strategies, based on the MPT assumptions, are divided into two main types: Strategic Asset Allocation and Tactical Asset Allocation. Strategic Asset Allocation is a traditional approach suitable for passive investors, requiring portfolios to be rebalanced only if desired allocations change based on changes in the investor's time horizon or risk profile. Tactical Asset Allocation is better suited for active investors, allowing investors to focus on assets outperforming the market. This strategy assumes that a sector outperforming the market may continue to outperform it for an extended period, allowing for some degree of diversification. Diversification does not require assets to be completely uncorrelated or inversely correlated, but it does not guarantee a beneficial effect.

Let’s consider these principles through an example portfolio. An asset allocation strategy may determine that the portfolio should have the following allocations between different asset classes:

• 40% invested in stocks

• 30% in bonds

• 20% in cryptoassets

• 10% in cash

A diversification strategy may dictate that among the 20% invested in cryptoassets:

• 70% should be allocated to Bitcoin

• 15% to large-caps

• 10% to mid-caps

• 5% to small-caps

Concluding Remarks

Asset allocation and diversification are fundamental concepts of risk management that have existed for thousands of years. They are also one of the core concepts behind modern portfolio management strategies.

The main purpose of devising an asset allocation strategy is maximizing the expected returns while minimizing the risk. Distributing risk between asset classes may increase the efficiency of the portfolio.

As the markets are highly correlated with Bitcoin, asset allocation strategies should be applied to cryptoasset portfolios with cautiousness.