MARKET PEOPLE

Essential knowledge for the middle class | Plain explanation of asset allocation, how to stand invincible in the market?

2023/2/10

"As long as you are alive in the world of investment and trading, there is always a chance," this is one of the few sentences that can be called 100% correct.

The topic we are going to discuss today, "Asset Allocation," allows us to wait for opportunities alive no matter how the market changes. This feature is particularly important in the cryptocurrency industry, as there are plenty of opportunities, but once you exit during a bear market, you may miss the chance to participate in future opportunities for wealth accumulation. Since the topic of asset allocation covers a wide range and can be explored deeply, the purpose of this article is to help you understand two things clearly and quickly:

What is asset allocation?
How to do asset allocation?

Finally, we will use practical examples to ensure that your investment and trading are built on a stable foundation, accumulating experience and moving up the ladder, rather than taking random shots and relying on luck for profit. Once you are ready, let's get started!

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This article is contributed by the founder of JZ Invest. A former traditional finance and cryptocurrency investment institution trader, holding CFA certification and BAYC.

Table of Contents

Basic Concepts of Asset Allocation

Asset allocation is a standard practice for institutional investors

One of the key differences between retail and institutional investors is the concept of asset allocation, which is based on the principle of risk control. Having the correct asset allocation, also known as portfolio management, is equivalent to having the most basic risk management concept.

When we talk about trading, it is just one aspect of asset allocation. However, most people focus solely on reading charts, predicting market trends, imagining they can control the market, only to often meet a cruel end in the ruthless market.

Asset allocation ensures we don't meet a cruel end!

If you're alive, you have a chance, and asset allocation allows us to stay in the market, waiting for opportunities.

The next section will discuss how to implement asset allocation, but first, let's introduce the relationship between risk and expected returns: "The higher the expected return, the higher the corresponding risk, but not necessarily vice versa."

In simple terms, asset allocation involves combining different strategies of expected returns, controlling them within a certain range, and keeping the risk within what we can afford.

The above is the most basic concept of asset allocation. Next, we will teach everyone how to implement asset allocation.

How to Implement Asset Allocation?

Next, we will introduce the steps of asset allocation, guide you through the process of asset allocation, and provide several real examples for better understanding.

Steps of Asset Allocation

The straightforward and essential steps of asset allocation are roughly as follows, mainly divided into 4 steps:

Assess the current financial market and economic conditions, as well as the worst possible future trends.
Evaluate all current assets, categorize them into emergency reserves and low, medium, high-risk investment positions.
Decide on the proportion of investment positions based on your financial situation, investment experience, etc.
Determine the investment and trading strategies for each position.

From my observation, most cryptocurrency investors only focus on a small part of the 4th step and consider it as "investment." They may make a big profit in a trade, but without proper asset allocation or risk control, they will eventually lose in the market due to "bad luck."

Therefore, most people often feel high pressure in investment trading, which affects their lives significantly. At this point, our emotions can lead us to make wrong decisions, creating a vicious cycle that eventually leads to market elimination.

Remember, if you believe that "investment is to improve and enhance your quality of life," then please implement proper asset allocation and don't treat the market as a gambling den.

Next, I will explain in detail points 2, 3, and 4, as point 1 requires a skill that needs to be developed over the long term. If interested, you can follow JZ Invest, where we will cultivate market sensitivity together. First, let's define what emergency reserves, low, medium, and high-risk positions are.

Risk Level Definitions for Positions

Everyone has different risk tolerance levels, so the definitions of low, medium, and high-risk assets will vary. Risk can be assessed using win rate, risk-reward ratio, expected value, and maximum drawdown (MDD). The following table explains how to interpret these 4 criteria.

After understanding the 4 criteria, applying them to determine low, medium, and high-risk strategies yields the following table.

Low-risk strategy: Emphasizes stable profitability with a win rate of over 95%, does not require high potential returns, but potential losses should be very low, with a maximum drawdown of less than 5%, and high liquidity for ease of liquidation.
Medium-risk strategy: Various ranges of values fall under medium risk, not classified as low or high risk.
High-risk strategy: Offers very high potential returns, relatively low potential losses, but also high medium risk. Win rate is usually below 20%, risk-reward ratio above 5, maximum drawdown could be 100%, requiring careful position risk management. Positions are usually long-term with poor liquidity.

What about emergency reserves?

You might have noticed that I didn't mention emergency reserves because it's straightforward. Just remember the two key points: "safety and liquidity."

One unique aspect in Taiwan compared to other countries is the potential for war. So, if you have over ten million New Taiwan dollars in cash, consider converting some of it to foreign currency and depositing it in a foreign bank to mitigate Taiwan's geopolitical risk.

Once you understand how to define each strategy, the next step is to determine the proportion of asset allocation.

Establishing Your Asset Allocation Strategy Based on Your Conditions

As mentioned earlier, asset allocation ratios vary from person to person. You can assess your risk tolerance based on the following 5 aspects. If you have low risk tolerance, increase the proportion of low-risk positions, and vice versa.

Cash flow: How stable is your income, and do you have a steady cash flow?
Capital needs: Do you have short-term financial needs, such as age, health, or family expenses?
Professionalism: Do you have expertise in financial investments? How much time can you dedicate to researching investments daily?
Opportunity cost: If you invest your time in investments, can you earn more stable income than in other activities?
Personality: Are you risk-seeking or risk-averse?

Considering the above 5 points should help you subjectively and objectively assess your risk tolerance. If you're still unsure how to start, you can refer to the examples I will provide next.

Real-life Examples of Asset Allocation

Using my Taiwanese friend as an example, we will quickly walk through the asset allocation process for your reference.

1. Assessing Current Financial Market and Economic Conditions

He is pessimistic about the global economic development in 2023 but sees limited downside potential from a capital market perspective. Despite his overall bearish outlook, he is looking for opportunities to buy assets.

2. Evaluating Current Assets

While he cannot disclose his total assets, he needs to consider the portion in foreign banks. Therefore, proper asset allocation is crucial, with approximately 3-5% of his total funds allocated as emergency reserves.

He plans to open a bank account abroad but currently uses a US stock brokerage account to wire money overseas. This allows him to diversify Taiwanese dollars into US dollars, trade US stocks, and mitigate Taiwan's geopolitical risks.

3. Deciding on Investment Proportions

Based on his financial situation and investment conditions:

His job income is not as stable as a regular employee but has a steady cash flow for investments.
He is in good health and has no family expenses to bear.
With 8 years of investment trading experience, he trades full-time.
He has expertise in financial investments, with a low opportunity cost for other activities.
His risk appetite is neutral to conservative but willing to take risks.

Considering the above conditions, he is a high-risk-tolerant investor. Excluding emergency reserves, most of his positions are placed in medium to high-risk strategies.

However, considering the current and future market conditions, he decides to allocate low, medium, and high-risk positions as follows: 30%, 50%, 20%, respectively, adjusting based on market conditions and future expectations, maintaining flexible liquidity in positions, with each position having a cash component.

4. Determining Investment and Trading Strategies for Each Position

Given his familiarity with the cryptocurrency industry and its numerous opportunities, he allocates most of his funds to the blockchain sector. Some funds are also allocated to Taiwan stocks and US stocks, with a focus here on blockchain industry strategies.

Low-risk: Bitfinex lending, exchange and on-chain arbitrage opportunities, exchange yield products, and risk-free opportunities.
Medium-risk: Event-driven strategy, trend-following on the right side, delta-neutral long-short strategies.
High-risk: Option strategies to capture market crashes, DCA strategies for long-term investments, left-side trading.

For more details on these strategies, he will share them on JZ Invest's Facebook and Telegram channels. Interested individuals can follow for more information.

If you have any questions about the above content, feel free to join JZ Invest's Telegram group, where I will help resolve issues and learn together!