Summary: Building a well-balanced crypto portfolio can help you reduce volatility risk and benefit from greater predictability. In this article, you will discover the best practices for obtaining crypto diversification.
If you want to be a successful investor, here are three words: diversify, diversify, diversify.
Diversification is an important investment concept, which helps reduce the risk of a portfolio by gaining exposure to multiple assets.
When it comes to crypto investing, the practice of spreading your investments across multiple digital currencies makes sense, as it can help reduce volatility in your portfolio.
That said, diversification can be achieved in a number of ways, and it’s the job of asset allocation to find the best mix of assets when constructing an investment portfolio.
The objective of crypto asset allocation is to balance the risk/reward ratio by adjusting the percentage of each crypto asset in the portfolio based on your medium to long term goals and risk tolerance.
Let’s look at some allocation and diversification strategies to balance risk and reward to get the best long-term performance from your crypto investments.
Different Crypto Classes
There are bitcoin maximalists, Ethereum proponents, DeFi (decentralized finance) enthusiasts – you name it. Although you may prefer certain types of crypto assets, it is best to be agnostic when it comes to crypto investing, in order to better diversify.
Understanding the different classes of crypto assets will make you aware of owning two or more assets that share the same characteristics and can perform similarly under certain conditions.
CoinDesk has developed a digital asset classification standard, which breaks down major crypto assets into a few useful categories:
Cryptocurrencies: These are virtual currencies that rely on proprietary blockchains. Bitcoin (BTC) is the most popular cryptocurrency and is in a class of its own. Examples of altcoins (or bitcoin alternatives) are Litecoin (LTC), Monero (XMR), and bitcoin clones like Bitcoin Cash (BCH) and Dogecoin (DOGE).
Smart contract platforms: This is the base layer or “Layer 1” operating systems of the blockchain, on which other crypto applications can be built. Ethereum is the leader in this category, with its ERC-20 standard, but there are many others including Cardano (ADA), BNB Chain (BNB) and Solana (SOL).
Challenge : Decentralized finance is one of the most successful use cases of blockchain technology, and most DeFi projects release their own tokens, including Uniswap (UNI), Aave (AAVE), Compound (COMP), Yearn Finance ( YFI) and Balancer (BAL).
Stable Coins: These are tokens whose price is pegged to fiat currency (usually the US dollar), commodities (like gold), or other real-world assets. The goal of stablecoins is to create a safe place for crypto investors to store their money, while acting as a bridge between the crypto economy and traditional economies.
Non-fungible tokens (NFT): These investments usually have a unique value and represent something irreplaceable. Although you don’t care if your bitcoin has been replaced by another, each NFT has a separate identity (and sale price). NFTs can represent digital or physical items, whether they are works of art, luxury goods or intellectual property.
While this list is slightly simplified from DACS, there are other ways to slice the cake, including by market cap (large-cap vs. mid-cap coins), by consensus algorithm (proof-of-work vs. proof-of-stake ), by infrastructure (layer 1 vs layer 2), by sector (DeFi, games, metaverse), etc.
The goal of diversification is to build a crypto portfolio with exposure to all types of crypto assets – ideally the long-term leader in each category.
Types of asset allocation
Since crypto assets are still new, most investment and analytical practices are borrowed from traditional markets. For example, one of the most important mathematical frameworks for constructing an investment portfolio is Modern Portfolio Theory (MPT).
MPT, which was introduced by Harry Markowitz seven decades ago and for which he received the Nobel Prize in Economics, helps investors maximize returns for a given level of risk.
MPT’s main assumption is that investors are inherently risk averse. Therefore, if two portfolios offer the same expected return, investors will prefer the less risky one. Thus, it only makes sense to take on increased risk when motivated by higher expected returns.
In line with the logic of MPT, combining uncorrelated crypto assets can reduce portfolio volatility. It should also improve risk-adjusted performance, suggesting that a portfolio with the same level of risk will produce better returns.
Since MPT refers to traditional finance, a typical asset allocation framework suggests that asset classes can be divided into traditional assets (cash, stocks, and bonds) and alternative assets (commodities, real estate, derivatives and crypto assets, among others).
We can borrow the same logic for cryptocurrencies: traditional assets could include bitcoin, Ethereum and well-established stablecoins, while alternative assets could be more volatile tokens: DeFi, metaverse, NFT, etc.
Within MPT, there are two main approaches to building a crypto wallet:
Strategic Asset Allocation: SAA is a traditional “set it and forget it” approach. Here you won’t be looking for rallies in a hunt for comebacks. Instead, the goal is to build and maintain a well-balanced portfolio with an appropriate mix of crypto assets to achieve your long-term goals. SAA portfolios only need to be rebalanced if your time horizon or risk profile changes.
Tactical Asset Allocation: TAA is suitable for more active investors. It allows investors to focus their portfolios on crypto assets that outperform the market, such as DeFi tokens. According to TAA, if an industry outperforms the general market, it may continue to do so for an extended period. (Of course, the trick is to “time the market”, which is hard to do.)
While the principles of SAA and TAA can apply to a crypto portfolio, the crypto market is ultimately correlated to the price of bitcoin, which makes diversification more difficult. Nevertheless, some tokens, such as those related to DeFi, may show lower correlation.
Examples of Diversified Crypto Portfolios
So what does a well-balanced crypto portfolio look like? Here are two examples:
Conservative: Those who prefer the SAA approach might consider the 80/20 rule, which assumes that 80% of your crypto portfolio is allocated to large-cap tokens (>$10 billion market cap) and 20% to small-cap tokens . For instance:
- BTC: 30% (large cap)
- ETH: 30% (large cap)
- ADA: 5% (large cap)
- XRP: 5% (large cap)
- SOL: 5% (large cap)
- BNB: 5% (large cap)
- AVAXL: 5% (small cap)
- MATIC: 5% (small cap)
- LINK: 5% (small cap)
- FTM: 5% (small cap)
Balance: If you prefer a more balanced investment but with a higher risk-reward profile, you can consider the 40/30/30 rule, in which 40% goes to Bitcoin and Ethereum (either 20/20 or 30/10) , 30% goes to large caps (>$10 billion market cap) and 30% to mid and small caps.
- BTC: 20% (large cap)
- ETH: 20% (large cap)
- ADA: 10% (mid cap)
- XRP: 10% (mid cap)
- SOL: 10% (mid cap)
- ATOM: 5% (small cap)
- AVAX: 5% (small cap)
- MATIC: 5% (small cap)
- LINK: 5% (small cap)
- FTM: 5% (small cap)
- UNI: 5% (small cap)
Remember, however, that either of these strategies will ideally be diversified within an overall investment portfolio of high quality stocks and bonds.
For an example, see our Blockchain Believers Portfolio, where crypto is a maximum of 10%. The percentages above would apply to this 10% slice of the cake.
Diversify your own crypto portfolio
Every investor is unique, so you should bring your own preferences and ideas to your crypto portfolio. But here are some general guidelines for success:
Divide your crypto portfolio between high, medium and low risk investments. Then, do the same for your overall portfolio, noting that most cryptos are high risk except for stablecoins.
Feel free to hold stablecoins (preferably USDC and USDT) to help provide liquidity to your crypto wallet. With stablecoins, you can quickly take profits or exit a position to avoid losses.
Rebalance your portfolio from time to time (we recommend taking a fresh look at two easy-to-remember days like January 1 and July 4).
When allocating new capital, avoid overweighting any part of your portfolio. If you’ve been successful in getting big returns from small caps, don’t increase your share in them, but instead maintain the balanced approach as per your initial strategy.
Most importantly, do your due diligence and only invest in what you understand and what you can afford to lose. It’s crypto: be prepared for anything.
Key takeaway for investors
To use our three words: diversify, diversify, diversify.
Crypto assets are extremely volatile, which is why diversification is a great strategy to protect yourself from risk, while enjoying the rewards.
Diversify your crypto portfolio by including different types of tokens with different risk profiles.
Diversify your overall portfolio by investing in high-quality stocks and bonds, with a small slice of the pie (no more than 10%) devoted to crypto.
Don’t put all your bags in one basket.
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