Diversification in cryptocurrency

Introduction:

Diversification in investing is a very common strategy and among investment managers is a highly recommended strategy. Diversification is spreading your capital out among different asset types or instruments. The idea behind diversification is attempting to maximize returns while minimizing risk because each asset class in your portfolio will react differently to each event.

Risk:

Most professionals realize that this is not the absolute best way to realize gains or protect against loss. However, it is one of the best ways to realize your long term investing goals while minimizing risk. But in order to minimize your risk, you have to know the different types of risk. In financial economics there are two types of risk: Firm-specific risk and systematic/market risk.

Firm-specific risk - Firm specific risk is like the name suggests; the risk you incurred for putting money into one firm - say apple. Your gains are entirely dependent upon apple’s success.
Systematic/market risk - This type of risk is subject to general market conditions like interest rate risk, war, political instability, natural disasters, or exchange rate risk, ect. Anything that has potential to create uncertainty in the markets could be considered a systematic risk.

Diversification:

Fortunately, for investors, you can hedge against firm-specific risk. If all your money is in apple you can diversify into microsoft, so if apple’s stock plummets you won’t be impacted as much because you own some of microsoft. However, you can go even further, if you choose. You could purchase stock across different industries, like tech, healthcare, transportation, banking, or other assets like bonds, currencies, and cryptocurrencies. That way when your tech stock loses value your cryptocurrencies will appreciate, balancing out your losses with gains. (That’s the idea at least)

Diversification is common because it’s a good strategy and a powerful one. Most retirement funds offered by the major players like Vanguard or Schwab have suggestions on diversification given your risk tolerance. And typically you’re required to take a risk tolerance questionnaire before investing. But diversification isn’t always an amazing strategy, particularly if you’re a young person and want to take on more risk. You have a substantial amount to gain from having one asset represent a significant portion of your portfolio, but also more to lose. That is particularly true in a asset class like cryptocurrency. Not only did 2017 see substantial gains in the overall market cap, and huge returns for investors but as the technology improves we could be seeing great long term growth. Which is why, for the younger people, using their money to speculate on a high return, high risk, asset class is a okay idea as long as you meet three requirements:

Have your finances in order. No massive debts or payments due.
You aren’t using debt/loans to finance your portfolio.
You have reasonable expectations of income growth in the near future - as to average down losses if you so choose.
Or just follow Dave Ramsey's 7 baby steps

But it’s always a good thing to decide your risk tolerance. I’d say only invest in cryptocurrencies if you have an aggressive or very aggressive risk profiles.

Diversification in cryptocurrencies:

But even if you love cryptocurrencies and want to be heavily invested in the space, I’d still recommend some diversification. However, there are a lot of people who seem to think investing in different cryptocurrencies IS diversification, while this is one possible solution for diversification is doesn’t work very well.

For one, cryptocurrency is it’s own asset class, and generally speaking diversification should be across industries.

But two, if you do decide to go this route, which I don’t suggest, I would look at correlations between different cryptocurrencies. If all your cryptos are highly correlated with each other, then a massive loss in Bitcoin will result in a mass loss across your portfolio. Further, all the crypto-coins are pretty highly correlated with Bitcoin looking at a crypto-correlation matrix can show you this. Although, that website also offers a glance at correlations between crypto and the S&P index, Gold index, and Treasury bonds. All of the traditional markets tend to show almost no correlations with the majority of cryptocurrencies which is a positive thing. As you can invest in stocks, bonds, gold, and crypto to get a very diversified investment portfolio.

Conclusion:

Ultimately, you’ll need to decide for yourself on what percentage of your portfolio you allocate to crypto. Evaluate your financial situation and your risk tolerance. And then consider a real possibility of losing 50-75% of that.

As for my investment portfolio it leans heavily towards crypto, even with the recent crash. It was 50/50, 50% stocks (mostly index funds) and 50% crypto. But currently, it’s more like 87% crypto and 13% stocks. I might rebalance that but because I am still young, have my finances in order, and expect reasonable income growth; I don’t feel as though I am over invested in crypto.

However, I might not feel that way if I was older. The recent crash in cryptocurrency took nearly half of all my profits. As an investor you have to realize that this a very volatile market and you must be willing to endure massive drawdowns.

Here are some suggestions for allocation:

Ages: 18-33 I suggest 50% - 25% crypto and 50% stocks/bonds
Ages: 33-48 I suggest 25% - 15% crypto and 75% stocks/bonds
Ages: 48-65 I suggest 10% - 1% crypto and 90% stocks/bonds

Disclosure:

I try to be as unbiased as possible but my opinions are my own.
Nothing here is financial advice, purely my own opinion.
As always, do your own research and do not invest more than you can afford to lose. Best of luck.

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