For every investor, the main goal is to maximize profits and eliminate risks – which is why they set investment objectives and implement a variety of strategies to capitalize on market trends. Part of these strategies entails investors allocating their funds to a range of asset classes. The whole idea is to invest a varying percentage of your capital in more than one asset such that the plunge in prices does not excessively diminish your profitability. This strategy encapsulates the very essence of portfolio diversification.
In other words, portfolio diversification is the act of allocating a varying percentage of your funds to different assets in order to maximize profit and reduce risk. When diversifying, more importance is placed on the probability of the prices of two or more assets to correlate. A well-diversified portfolio consists of assets that tend to perform differently.
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.
Nonetheless, many investors assume that adding Bitcoin alone to their portfolio is enough. They argue that Bitcoin embodies everything that crypto has to offer. And so, instead of adopting a crypto portfolio diversification plan, they allocate all their funds to a single digital asset out of the over 5,000 coins that currently exist. Although Bitcoin has recorded impressive price surges over the years, nothing beats a well-balanced portfolio that capitalizes on the heterogeneous makeup of the crypto market.
Why Is Crypto Portfolio Diversification Important?
Unlike a majority of traditional assets, the digital assets market is quite volatile. Prices can suddenly shift in different directions several times a day to the advantage or detriment of investors. Therefore, just as volatility tends to increase profitability, it also multiplies the possibility of incurring losses. It is common for the price of Bitcoin to experience a 50% drop in a matter of days. In such instances, investors who are heavily invested in the Bitcoin market would see a sudden crash in the value of their portfolio.
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.
For example, while Bitcoin might be experiencing a 50% downturn, Ethereum, on the other hand, may be only down by 25%. Adding a stablecoin to the mix further reduces the risk. And luckily, DeFi tokens could be recording price gains. In the long run, the combined performance of digital assets in a well-diversified portfolio may offset the losses incurred by individual investments.
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.
Furthermore, diversification functions as a profit-maximizing strategy in certain market conditions. This was evident in the DeFi boom of 2020. During this period, the DeFi sector outperformed other segments of the crypto market. In contrast, established coins like Bitcoin and Ethereum were hardly making any splash. As such, investors that had thought it wise to add DeFi tokens to their portfolio were better placed to generate more profits.
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
- Stablecoin: Dai and USDC
- Smart Contract Cryptocurrencies: Ethereum and Binance Coin
- DeFi Tokens: Aave and Compound
- Non-Fungible Tokens: Decentraland and Chiliz
- Privacy Coins: Monero and Dash
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.
This method is also called dollar-cost averaging, and it involves an interval-based investment plan. All you need to do is invest fixed amounts on your preferred tokens in predefined intervals. This approach eliminates the need to identify the best time to enter a market or purchase a coin.
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.