Cryptocurrency is no different than any other asset class as one careless mistake can result in potentially life-altering financial damage. As such, it is vital for everyone from newbie investors to seasoned exports to ensure a risk-appropriate basket of multiple cryptocurrencies.
This isn’t really asking for too much. It is quite easy to legally buy and sell different cryptocurrencies through online platforms like Swep.io.
The difference between diversifying or not could be the deciding factor between losing a down payment for your house that would be catastrophic or losing three months of income that could be easily recovered through a temporary disciplined lifestyle.
Digital Currencies Aren’t Created Equal
Assuming that all cryptocurrencies perform the same function and target the same user base is a big mistake many people make. These investors are likely to acquire one or maybe two cryptocurrencies and call it a day.
Many assume that Bitcoin, Litecoin, Ethereum, XRP, Tether, and EOS are all the same then why not just buy the cheapest one or two and hope for the best. Sure, they might get lucky and score a jackpot-like return, but let’s face it: the odds of this happening are extremely unlikely.
Instead, it is best to understand the different use cases of cryptocurrencies and to perhaps buy one coin from each category.
Some of the categories and examples of cryptocurrencies include:
Store of value: Bitcoin.
Connected Internet of Things: IOTA.
Tradeable Digital Assets: WAX.
Decentralized Finance: Maker.
So as we can see, a diversified portfolio of different cryptocurrencies would consist of cryptocurrencies selected from multiple categories.
A parallel example in the stock market universe might look like:
Physical retail: Simon Properties.
Travel: Delta Airlines.
Restaurants: Chipotle Mexican Grill.
From a historical perspective, buying just Apple could result in exceptional gains or losses depending on the timeframe. In fact, in early January 2019, the stock erased years’ worth of gains and traded at its lowest level since July 2017.
Part of a portfolio diversification strategy includes minimizing individual risk. While a certain degree of risk might be appropriate, investors need to accept a potential 100% loss for it to fit within the portfolio’s risk parameters.
Much like stocks, it is often difficult to determine the risk associated with an investment. Will Amazon’s e-commerce business continue growing without the external risk or will rival Walmart find a way to leverage its physical retail footprint to beat Amazon in the online space? Maybe. Maybe not.
But it would be foolish to leave out Amazon as at least a small part of a portfolio given its successful track record to date.
Some of the warning signs that cryptocurrency investors could look out for to identify riskier assets include a coin’s stage of development. A digital currency that exists solely in the “white paper” stage stands a higher risk of never being implemented. An existing digital currency that has grown over the months or years is deemed safer because of a small track record.
Equally important is to take the time to research if a cryptocurrency offers a legitimate solution to a problem or if it is backed by glitzy marketing and buzz. Sites like DappRadar exist to rank decentralized apps (dapps) by certain metrics, like daily users, volume, and more.
Perhaps the best way to identify risk associated with a cryptocurrency is to follow what the crowd is doing. Major venture capital firms are known to dabble in the cryptocurrency universe and they are backed by what seems like unlimited resources and research tools. If an investment idea is good enough for them, surely it has room to fit into your portfolio.
Conclusion: Diversification Is A No Brainer
How exactly one diversifies their portfolio depends on their individual situation. For some, a properly diversified portfolio would consist of 10 cryptocurrencies across 10 use cases — each accounting for 10% of the total value of the portfolio.
For others, a diversified portfolio could consist of 50% in bitcoin and 5 to 10 other digital currencies.
Finally, a proper diversification strategy requires constant monitoring and adjustments. This may even include selling a hot performer to lock in gains and maintain a portfolio that is consistent with the original balancing objectives.