With the volatile digital assets markets, crypto portfolio diversification is increasingly important. What is it, and how exactly do you diversify your crypto portfolio?
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Portfolio Diversification in Investing
Diversification as an investment strategy cuts across all financial markets. Seasoned investors understand the importance of allocating their funds across multiple asset classes in order to find a balance between risk and reward. However, many do not know that this strategy is also relevant when allocating funds within asset classes.
Although the distribution of your capital to a broad range of financial markets like bonds, stocks, commodities and crypto is a good start, this strategy is even more effective when you diversify each asset class further. For instance, a stock portfolio should embody multiple segments of the stock market, including energy stocks, tech stocks, healthcare stocks and so on. This is also true for your crypto portfolio.
Why Is Crypto Portfolio Diversification Important?
To mitigate such levels of risk exposure, it is advisable to spread one's funds across a range of digital assets. This investment strategy reduces the magnitude of losses incurred in times of market downturn. Since you have invested only a fraction of your fund in Bitcoin and distributed the remaining to a variety of coins, it is unlikely that a 50% Bitcoin crash will be as devastating. This is because the performance of the constituent crypto-assets of a diversified portfolio would balance out the losses.
Note that the risk inherent in a Bitcoin-focused strategy is also present in an investment plan that focuses on Ethereum or any other digital asset. The goal here is to ascertain that you are not heavily invested in a single cryptocurrency be it Bitcoin, Ethereum, Binance Coin, or any of the 5,700 other digital assets.
What Happens When All Diversified Crypto Assets Crash?
You may argue: What happens when all the assets in a diversified crypto portfolio crash as the price of cryptocurrencies tend to correlate? Does this diminish the efficacy of crypto allocation?
In such scenarios, you have to look at the positives. One of the positives is that the possibility of incurring devastating losses is considerably low. From the example above, both the prices of Bitcoin and Ethereum are down. However, the loss incurred by an investor holding both assets is not as high as that of an individual solely investing in Bitcoin. As such, we can call crypto portfolio diversification a risk management strategy.
How Do You Diversify Your Crypto Portfolio?
When diversifying your portfolio, the most important thing to look out for is price correlation. Try as much as possible to hold digital assets that do not tend to trail themselves. Having too much of these assets in your portfolio reduces the effectiveness of this strategy. You may be wondering: How can you identify non-correlating digital assets? Well, there are various ways to go about this.
Diversify By Crypto Classification
This diversification method considers and includes varying types of cryptocurrencies. Some of the types of cryptocurrencies we have today are:
- Store Of Value Assets: Bitcoin
- Payment Coins: Bitcoin Cash and Litecoin
- Smart Contract Cryptocurrencies: Ethereum and Binance Coin
- Non-Fungible Tokens: Decentraland and Chiliz
Do note that the coins mentioned above are examples of different types of cryptocurrencies and not financial advice to buy.
The goal is to have all the classes of cryptocurrencies well-represented in your portfolio so that you are always rightly positioned to capitalize on the explosion in demand of any of them.
Diversify By Industry
You could also focus on the use cases of digital assets and gauge the potential of such applications. Ensure that you invest in a dynamic list of coins that provide viable solutions for a wide variety of industries. With this, you can reduce the adverse effects of industry-specific crypto-unfriendly regulations and events on your investment.
Diversify By Geography
Ascertain that all your funds are not allocated to crypto projects based in the same region or country. This measure will protect your investments from regulatory uncertainties.
Drawback Of Crypto Portfolio Diversification
Just as diversification reduces risks, it also diminishes the return on your investment. Note that the profits generated by your high-performing assets would be weighed down by the losses incurred by other assets.
Due to the excessive volatility of the crypto market, it is imperative to adopt efficient risk management techniques. As discussed in this guide, one of such practices requires a dynamic approach to fund allocation. When done right, portfolio diversification is an efficient risk-mitigating approach to crypto investment.