If you’re old enough to read this, you likely have experience with a parent telling you ‘not to put all your eggs in one basket’ when it comes to dating, applying for college, or buying a car. Its simple advice that transcends all aspects of life—putting all your resources into a single item or focus can have unpleasant results.
Investing is no different, especially when it comes to crypto investing. Putting all your capital into a single asset can be risky, which is why many asset managers preach the benefits of investment diversification in portfolio management.
In 1952, professional economist Harry Markowitz developed (make link rel=nofollow) Modern Portfolio Theory. Markowitz showed how investors could use uncorrelated assets within a portfolio to offset their individual risk without drastically reducing returns. The goal was to achieve a portfolio with the best ‘risk-adjusted return’ or the maximum return based on a portfolio’s level of risk.
Modern Portfolio Theory attempts to quantify investment diversification and is still used in portfolio building today. Why is diversification so important in investing? By not hoarding similar assets, investors can withstand steep declines in a single stock, commodity, or cryptocurrency without causing too much damage to the overall portfolio. Mutual funds and (make link rel=nofollow) ETFs in the stock market were created so investors could hold a diverse portfolio of assets within a single security.
Consider two crypto portfolios of equal value: Portfolio A consists of 100% BTC, while Portfolio B consists of 50% BTC and 50% ETH. If BTC and ETH each drop 25%, both portfolios will lose the same amount of money. But if BTC drops 50% and ETH drops only 20%, Portfolio A is down 50% while Portfolio B is only down 35%. If BTC and ETH recover from these hypothetical declines at the same rate, the more diverse Portfolio B will be far ahead of Portfolio A in long-term returns.
One drawback of diversification is that buying uncorrelated assets will naturally limit returns. For example, suppose you have a crypto portfolio with eight equally-weighted assets. In that scenario, you won’t see immediate profits if one of your cryptocurrencies triples overnight, since only 12.5% of your capital will be invested in that particular asset. So if you want a profit-maximizing portfolio, you’ll need a different approach to crypto diversification.
How much should you diversify your crypto portfolio? There’s no concrete answer to placate every investor; the amount of risk you are willing to shoulder will determine your crypto diversification strategy. Newer investors will likely want a portfolio with multiple cryptocurrencies to offset some of the risk inherent in each asset. Experienced risk-tolerant investors may consider just 2-3 assets sufficient for crypto diversification.
Figuring out your personal risk tolerance is the first step when thinking about crypto diversification. There’s no denying that cryptocurrency is a high-risk investment. The volatility is frequently fierce, and not having a plan could lead to a lot of buying high and selling low. How much capital are you willing to devote to a single asset? How much of a decline are you willing to tolerate in both a single asset and your overall portfolio? And what are your profit goals for each investment? Ask yourself these questions before investing in cryptocurrency.