Diversification Is the Key to Investing in Stocks and Bonds. Here's Why It Can Work for Crypto, Too
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Mark Farfan treats crypto as a mixture of investing and gambling.
He's a long-term holder who only puts in what he's comfortable losing. While most of Farfan’s crypto portfolio — 80% — is in coins he’s confident are here for the long haul, like Bitcoin and Ethereum, he’s also branched out into smaller coins like Cardano, Litecoin and Stellar. The 30-year-old from Ottawa says the more coins he bets on, the more likely to bet on one that takes off.
“I’m not going to pretend that I'm some crypto genius,” Farfan says. “It’s pure luck.”
If you follow the basic rules of long-term investing — rebalancing regularly so you have a diversified portfolio — you're probably familiar with the idea that you don't want to invest too heavily in one asset or security. And if we're going with the rationale that we don't want to put all of our eggs in one basket, then it makes sense to diversify your crypto investment in more than just one token, says Anjali Jariwala, founder of FIT Advisors.
But “diversifying” a crypto portfolio is much different from diversifying a portfolio of stocks and bonds. Here's how it can — and can't — help.
The benefits of crypto diversification
Diversification traditionally has two benefits: It provides your portfolio with "non-correlated" assets so that when some investments tank others hold steady or even rise in value, and it (ideally) protects you from catastrophic loss if one of your investments implodes.
The first benefit only faintly comes into play with crypto. A traditional investment portfolio benefits from the fact that bonds tend to rise in value when stocks fall, helping investors ride out bear markets. By contrast cryptocurrencies tend to rise and fall together.
The real benefit of diversification in cryptocurrency is to limit extreme outcomes. If one cryptocurrency fails and your investment goes all the way to zero, other crypto investments may still do well, Jariwala says. Ideally, your whole crypto portfolio won't be wiped out because of one coin.
Of course, diversifying could potentially limit your winnings. But, look at this way. Owning 10 coins instead of one improves your odds of getting a ride to the moon, even if, perhaps, it eliminates your chance of getting a ride to Pluto.
Investing in smaller projects and coins whose functionality is core to the decentralized finance (DeFi) ecosystem in general is also a good way to profit off of the future of cryptocurrency, says Anastasiya Belyaeva, head of growth at PieDAO, a platform that offers investors a range of crypto portfolios.
DeFi refers to a form of finance that doesn’t depend on third-parties like banks or governments. But that lack of regulation also comes with risks. DeFi-related losses from crimes like hacks and fraud hit an all-time high in the first seven months of 2021, according to a report from CipherTrace, a crypto intelligence company.
Limits of crypto diversification
The fact that all digital coins are correlated, however, poses a big problem for the argument for diversification. When Elon Musk tweeted that Tesla would no longer accept Bitcoin, for example, the price of tons of other cryptos also plummeted.
The exact reason that cryptocurrencies are so tied to Bitcoin's price is still uncertain, says Hanna Halaburda, an associate professor at NYU Stern School of Business. But one possible reason is that those who are enthusiastic about Bitcoin are also enthusiastic about crypto in general, she adds. Another is that the issues that plague Bitcoin, like environmental concerns and regulatory issues, are problems for the cryptocurrency space as a whole, she adds.
Because diversifying with a coin like Litecoin won't necessarily provide you diversification from Bitcoin, you want to make sure your overall portfolio is well-diversified with a mix of stocks and bonds. The percentage allocated to each will vary based on your age, financial situation and goals. And remember that cryptocurrency is not something to bet your life savings on, even if you’re diversifying your investments. Financial advisors tend to recommend keeping investments in risky assets to between 2% and 5% of your portfolio at most.
How to diversify your crypto portfolio
So, where should you start?
“If you’re a newcoming investor, betting on coins and projects that have been around for a bit of time and have proven that they are at least not a scam is a good idea,” Belyaeva says. “Investing in something that’s been around for a couple of weeks is probably on the risky end for newcoming investors.”
Bitcoin and Ethereum should comprise at least half of an investor’s cryptocurrency portfolio with other promising coins and tokens making up the rest, says Greg King, CEO of Osprey Funds, which offers the Osprey Bitcoin Trust.
Beyond that, it’s best to still stick with cryptocurrencies that are definitely legitimate — especially if you aren’t too familiar with the crypto space. Sites like Coindesk have a breakdown of cryptos by market cap, and provide additional information about each coin.
As far as how many coins to include in your portfolio, it depends on the investor and the risk tolerance. If you’re going to invest in smaller coins, for example, then you want a larger number of them, Halaburda says. And if you’re really worried about volatility but still want to invest in cryptocurrencies, consider stablecoins, which are backed by a reserve asset like the U.S. dollar or gold.
PieDAO’s portfolios range in size. Some have 5-6 coins — like DeFi+S, PieDAO’s "small cap" portfolio of high-growth, early stage DeFi projects — while others have around 16, including Bitcoin, Ethereum and other crypto assets.
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