Diversification is considered to be a very important aspect of Modern Portfolio Theory, which was developed in 1952 by Harry Markowitz who believed that returns from a portfolio may be maximized by diversifying the assets. In the context of cryptocurrencies, uncorrelated coins may exhibit lower risks. Coins which exhibit correlation are likely to increase in value by similar measures.
Benefits of a Diversified Portfolio
With a diversified portfolio, one can manage the high risks of volatility in the cryptocurrency sector. By diversifying a cryptocurrency portfolio, one can reduce exposure to operational risks that may materialize. A diversified portfolio also makes it easier to gain profits in a shorter space of time in bull markets. However, this is not always the case. One of the factors that may affect the outcome is technology, which determines the utility of a diversification strategy.
The risks tied to a protocol may be a factor to consider when diversifying portfolios. Different cryptocurrencies operate on blockchains with different protocols. Protocol provides the infrastructure to build applications. It is the foundational layer of code that determines the rules of the network. Different blockchains have unique protocols which exposes them to different types of risks.
Return Models of Cryptocurrencies
Combining coins with different return models can prove to be effective in some cases. There are different types of return models in the cryptocurrency sector which can provide unique advantages for one’s portfolio of cryptocurrency. These return models include passive holding coins, staking coins, and dividend generating coins.
Returns from passive holding coins is determined primarily by the changes in price of the coin that occur over time. Demand for the coin as well as other key factors such as operational risks, play significant roles in the value of the coin. Unlike passive coins, holders of dividend-generating coins and staking coins can make profits not only from the price of the coin but also other monetary rewards.
Holders of cryptocurrency may stake their coins in order to gain rewards. Blockchains with proof of stake consensus may carry out staking. DASH, for example, gives rewards to holders of at least 1,000 DASH in return for securing the network.
Dividend-generating coins, like dividend stocks, provide holders with monetary rewards. Due to legal and regulatory uncertainty, these types of coins are not common. There are few people who truly understand the types of reward models that meet the requirements of securities laws.
Reducing the Risks
Many experts would strongly advise investors to use stable coins to hedge against the risk exposures of their basket of cryptocurrencies. There have been many moments where the markets plummet, leaving holders of cryptocurrencies with significant losses. For this reason, it is advisable to maintain a portion of one’s portfolio in stablecoins.
It is important to develop a good knowledge base on coins for your portfolio. Without adequate research, risks of losses from holding a cryptocurrency may be higher than expected. By building a sufficient knowledge base of coins, one can better understand the nuances of each coin, thus becoming better at choosing coins that are most suitable to their needs. It helps to be honest with yourself about what coins provide the best advantages for your coin.
Keeping abreast of coin-specific risks can save losses that could result from isolated events in relation to a specific coin. Such losses can have a significant effect on profits if they constitute a significant proportion of a portfolio. If the coin-specific risks of a coin are especially high, an investor may be advised to reduce their holdings in such a coin or at least increase their investments in other coins.
The Case Against Diversified Cryptocurrency Portfolios
While virtual assets are becoming more uncorrelated with time, they still share a significant amount of correlation which, to many, suggests that diversification of a cryptocurrency portfolio may not be the wisest move (yet) for the mitigation of risks.
Most coins are still highly correlated, exhibiting similar price trends. Outliers include Tron and BNB. Tron is an outlier due to the bull run which occurred before the launch of BitTorrent (BTT). Several major milestones by Binance in 2019 caused an increase in the price of BNB. Such events include the launch of a decentralised exchange testnet, IEOs, and the BitTorrent offering which required buyers to use TRX or BNB.
Holding a large number of coins may prove to be a more effective strategy in the long-term. For now, the decrease in correlation between coins may not be enough to gain the advantages of a diversified portfolio.
There are several types of risks which may be significantly increased with a highly diversified portfolio of cryptocurrencies. Investing in a disproportionately high variety of cryptocurrencies is like gambling. In the words of Warren Buffet, “Diversification is a protection against ignorance. It makes little sense if you know what you are doing.”
Edel is an Editor with a decade of print and digital media experience – specializing in Science, Technology, Finance, Entertainment, and Advertising. He is also a stock and cryptocurrency investor. When Edel is not editing or analyzing charts, you can find him with his DIY lightbox taking timelapses of plants.