Asset Allocation Strategies & Why Diversification Matters

January 16, 2023

Asset allocation is a crucial aspect of investing and one of the most important decisions an investor can make. It involves dividing your investment portfolio among different asset classes such as stocks, bonds, cash, and alternative assets.

The goal of asset allocation is to balance risk and return, by diversifying your investments, you can potentially maximize returns while minimizing risk. This article will examine different asset allocation strategies that investors can use to diversify their portfolios and achieve their financial goals.

What Is Asset Allocation?

Asset allocation is the process of dividing an investment portfolio among different asset categories, such as stocks, bonds, real estate, mutual funds, derivatives, cash and cash equivalents.

The allocation is based on an investor’s goals, risk tolerance and investment time horizon. By diversifying investments among different asset classes, investors can potentially reduce the overall risk in their portfolio while maximizing returns.

Why Asset Allocation Is Important

Asset allocation is important because it may help investors achieve their financial goals while managing risk.

By diversifying investments among different asset classes, an investor can potentially reduce the overall risk in their portfolio. This is because different assets have different levels of risk and return, and by spreading investments across various asset classes, an investor can reduce the impact of poor performance by one specific asset.

Additionally, by periodically rebalancing the portfolio to align with the investor’s goals and market conditions, investors can optimize their portfolio’s return potential while keeping the risk under control.

Diversification with Alternative Assets 

One way to diversify a portfolio is by including investments in alternative assets such as real estate, Contemporary Art or precious metals. Alternative investments are strong portfolio diversifiers because their returns are not correlated with traditional market returns. 

Contemporary Art is one asset that has consistently offered negative or zero correlation with the S&P 500 Index as well as other alternative assets, meaning those investments are safe from market fluctuations that may impact equities, bonds and even real estate

The value of Contemporary Art is determined by a number of factors, including the artist’s reputation, the rarity of the piece, and the overall market demand.

Additionally, Contemporary Art can be a strong long-term investment as the value of art tends to appreciate over time. During periods of high inflation and during recessions, Contemporary Art has outperformed even other safe-haven assets such as gold and real estate. 

Common Asset Allocation Strategies

Strategic Asset Allocation

Strategic allocation sticks to a base policy mix, keeping the mix of assets based on expected rates of return for each asset class. Target allocation depends on the investor’s risk tolerance, time horizon and investment goals.

As those factors change over time, along with expected returns, strategic asset allocation usually requires occasional rebalancing. However, this strategy is compatible with a buy-and-hold strategy, as rebalancing only needs to be adjusted every now and then.

This approach uses diversification to reduce risk and improve returns, similar to a buy-and-hold strategy. For example, a portfolio with strategic allocation may have 40% equities, 40% fixed income and 20% cash equivalents. One with this portfolio may rebalance annually.

Tactical Asset Allocation

Tactical asset allocation is an active management portfolio strategy, best suited for active traders.

A diversified portfolio using tactical allocation adjusts the percentage of assets held in various categories to take advantage of marking pricing anomalies and timing the market.

This strategy allows portfolio managers to attempt to create extra value by taking advantage of short-term volatility and specific situations for individual stocks or sectors.

Tactical asset allocation calls for market timing and requires considerable investment management experience. For example, if your base allocation is 70% equities and 30% fixed income, but you forecast equities to give high returns in the short term, you can tactically increase your equity allocation to 80% until you think equity valuation is too high.

Tactical allocation can also be applied within asset classes. For example, a mutual fund may invest 50% in large caps, 15% in small caps and 35% in fixed income. If the fund manager anticipates that small caps will see greater investment returns in the short-term, they may tactically reduce their weighting of large caps to increase the allocation of small caps until that trend changes.

Dynamic Asset Allocation

Dynamic asset allocation is another active asset allocation strategy that diversifies your portfolio based on macroeconomic and stock market trends. A portfolio using this strategy is constantly changing the mix of assets as market returns rise and fall.

With this strategy, you sell assets that decline and purchase assets that increase. Using this approach, you continually rebalance your portfolio based on current capital market conditions.

Factors Impacting Asset Allocation

When making investment decisions, an individual investor’s personal preferences and circumstances will play a role. Some investors may prefer to work with a financial advisor to help with financial planning and wealth management.

Investment Objectives

The factors that determine a person’s investment and risk strategy are their individual goals. These goals may include a desired level of return or savings for a specific purpose or desire. As a result, varying goals will impact the way in which a person chooses to invest and take on risk.

Risk Tolerance

Risk tolerance is the measure of an individual’s willingness and ability to accept a potential loss on their original investment in exchange for the possibility of a higher return in the future.

Individuals who are more risk-averse tend to favor more secure assets and avoid taking on significant risks in their portfolios. On the other hand, those who are more aggressive investors may be willing to take on a larger amount of risk in pursuit of higher returns.

Time Horizon

The time horizon factor is determined by the length of time an investor plans to hold onto their investments. This is often linked to the investor’s goals. Additionally, different time horizons require different levels of risk tolerance.

For instance, an investor with a long-term investment strategy may be more willing to invest in a higher-risk portfolio because market conditions may change in their favor over time. However, investors with shorter-term goals may choose to avoid riskier investments and instead opt for more secure options.

The Bottom Line

Asset management is an important aspect of investing that involves creating a balanced portfolio of different financial assets to minimize risk and maximize returns.

One of the key strategies in asset management is asset allocation. It involves diversifying a portfolio among different asset classes in order to spread risk and maximize returns.

However, it’s important to keep in mind that economic conditions and market trends can change rapidly and can have a significant impact on the performance of different assets. In bear markets, for example, stocks tend to perform poorly, whereas bonds tend to perform well.

Therefore, investors should have an asset allocation strategy that attempts to adapt to changing economic conditions and market trends. This will help them to make informed decisions and to navigate bear markets with more ease.

Diversify with Contemporary Artwork 

Every asset allocation strategy is designed to best diversify your portfolio to help maximize returns and minimize risk. One asset to consider diversifying with is Contemporary Art.

Contemporary Art has proven to be a valuable asset class, with returns that can rival those of stocks and real estate. Plus, owning a piece of a masterpiece is a unique and exciting way to invest.

Over the long term, Fine Art has had a low correlation with all broad asset classes including stocks, bonds and emerging markets.

According to Citi Private Bank 2022 research, Post-War & Contemporary Art has a -0.04 correlation with developed market equities and a -0.18 correlation with high-yield bonds. When comparing to additional assets, Contemporary Art shows little to no correlation to investment-grade bonds (0.15), hedge funds (0.15), private equity (0.10), real estate (0.15) and commodities (0.18). 

This means that if the stock market is performing poorly, the value of contemporary art may still be increasing, which can help to balance out the overall performance of the portfolio and reduce risk.

Furthermore, owning a piece of a masterpiece is a unique and exciting way to invest, it’s not only an investment but also a piece of art that can be enjoyed and appreciated. 

However, it can be difficult for an individual investor to own a piece of a $10 million painting because of the high cost. A platform like Masterworks offers fractionalized shares of some of the most sought-after contemporary art, including works by Banksy, KAWS and Basquiat, this allows you to own a piece of a $10 million painting for a fraction of the cost.

Not only does investing in Contemporary Art offer the potential for strong returns, but it also allows you to diversify your portfolio and potentially hedge against market fluctuations.

The information in this article is given for educational purposes only. This information is not to be construed as investment advice, and should not form the basis of an investment decision.

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.