Explain Crypto Assets Diversification.
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.
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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.
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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.
Main benefits of asset diversification
Minimisation of loss risk: With asset diversification one can minimise their losses from any one asset class. This happens because if one asset/asset class is performing poorly another asset/asset class is performing better than average.
This helps balance out the result and reduces loss prospective in portfolio.
Preservation of Capital: Diversifying assets helps reduce the chance of loss of capital. Investment in debt instruments assures fixed return and safety of capital, having this as part of your portfolio ensures capital preservation.
Generating better returns (at similar levels of risk): With asset diversification, there is a higher possibility for better returns.
There are market rallies when certain asset classes perform extremely well and having a diversified portfolio better ensures you benefitting from this. Having equity during a bull market phase allows for higher than average returns. And having debt during a bear market allows decent returns even with drop-in equity portfolio.
Arbitrage Trading in Cryptocurrency and its benefits.
Arbitrage trading is a trading strategy that aims to generate profit by simultaneously buying an asset in a market and selling it in another. This is most commonly done between identical assets traded on different exchanges. The difference in price between these financial instruments should, in theory, be zero since they’re quite literally the same asset.
The challenge an arbitrage trader, or arbitrageur, has is not only finding these pricing differences, but also being able to trade them quickly. Since other arbitrage traders are likely to see this difference in price (the spread) as well, the window of profitability usually closes very fast.
On top of that, since arbitrage trades are generally low-risk, the returns are generally low. That means arbitrage traders not only need to act quickly, but they need a lot of capital to make it worth it.