The crypto market is highly speculative, causing the value of your portfolio to shift erratically on occasion. Much as they would with any other portfolio, cryptocurrency investors will also diversify their portfolio to mitigate their unsystematic risks. Many crypto investors invest in Bitcoin, and maybe a bit of whatever coin has caught their eye lately and HODL them. Cryptocurrency portfolios are often diversified within themselves with high amounts still favored towards Bitcoin and low dedications to other cryptocurrencies.
Bitcoin is still considered the father, as well as the most popular cryptocurrency and henceforth, the majority of the new investors, step into this battleground with Bitcoin. Lower amounts can then be allocated to earlier and higher risk projects such as lower capitalization altcoins and ICOs. The majority of cryptocurrency exchanges offer a wider selection of cross-crypto pairs than they do fiat/crypto pairs. In fact, some exchanges don’t even accept any type of fiat currencies altogether. That’s why many traders have no choice but to trade one cryptocurrency against another. Bitcoin (BTC) versus Ethereum (ETH) gives you the BTC/ETH pair, for example. Experts in this market are categorizing cryptocurrencies to help investors construct a market which will help their investors maintain a diversified portfolio. Some of the categories are the following:
Store of Value — Bitcoin, Digix
World Computer- Ethereum, NEO, EOS, Cardano, Tron
Payment Rail- XRP, Stellar, Bitcoin Cash, Monero, Dash
Connected IoT — IOTA
Cloud Storage — Siacoin, Storj
DAPPs- Basic Attention Token, Steem, Augur, Funfair
Stable Coin- Tether, PAX, DAI, USD Coin, Gemini Dollar
Decentralized Finance- Maker
Cryptocurrency Exchange Utility Tokens- Binance Coin, Kucoin, Qash
Tradeable Digital Assets — WAX
There are various strategies invented for naive investors that divide the weight of investments according to investor’s risk tolerance. The variety travels from pro-bitcoiners, top-6 safety keepers, Whales with one heavy investment and tiny in the rest, and hedgers who can have a strengthened game with the stable coins.
Portfolios including many different financial instruments with different asset classes are considered to be more stable than portfolios including only one financial instrument. “Don’t put all your eggs in one basket” as they say. In most cases, the diversified portfolio provides its owner with higher returns and lower risks. Traditionally, one of the main requirements for a diversified investment portfolio is including many different assets with no positive correlation between each other. In this case, if one of your assets loses its value, others either remain stable or rise, overlapping your losses and providing stability of your investment portfolio. The purpose is the reduction of volatility and downside to minimize the risk/reward ratio. There’s a whole field devoted to doing this called Portfolio Theory, but the goals of diversification are pretty clear: reduce the risk of permanent loss and reduce volatility.
That’s where the main difference between traditional financial diversification and cryptocurrency diversification occurs. The most popular cryptocurrencies are highly correlated with Bitcoin, which defines the direction of the cryptocurrency market in general. The effectiveness of diversifying within the cryptocurrency segment of the portfolio is also highly questionable. Cryptocurrencies are highly correlated. In case some technical or security problem happens to your main asset, it may either lose in its price or even collapse completely. One of the other factors making cryptocurrency markets even more unpredictable and unstable is the influence people’s behavior has on cryptocurrency prices, especially the influence of opinion leaders. This means that investors may just be adding trading fees to their portfolio. There are many similar arguments which explain why diversification in cryptoassets makes little sense, including the network effect of money
Most of the days where Bitcoin was having a bad day in the last two years, the majority of other cryptocurrencies were, too. The following figure, for example, shows a snapshot of the top 12 cryptocurrencies on August 29, 2019. All are in red. In fact, 94 out of the top 100 cryptocurrencies by market cap were plummeting this day.
Similarly when the Bitcoin turns green, and so did the majority of the cryptos in the top 100 besides USDT. A day later on August 30, the correlation is still observed with 93 cryptocurrencies in top 100 moving between 0–4%.
Cryptocurrency correlation matrix in 2017–2018 with S&P 500, CBOE Volatility Index, and Gold
Most of the cryptocurrencies we see today are the results of robust marketing campaigns that have helped them to gain popularity as a cryptocurrency which is overcoming the shortcomings of Bitcoin. They all exist in a digital domain and hence, it’s not their popularity but their underlying code which gives a more apposite measure of their potential and reality. Strenuously analyzing thousands of lines of codes daily and obtaining outcomes that explain the project’s competence is still a next-to-impossible task for the experts. Consequently, the marketing story is used as a shortcut to evaluate the projects displaying only the cover of the book. A few may evaluate the code (if it’s available), but most use the marketing story because it’s cheaper and easier. This causes delays in the project developments and the roadmaps are extended to unknown timelines. The investors invest in the project after analyzing their team, social media presence, GitHub activity, word of mouth, social reviews, and perception. In other words, exaggeration in marketing doesn’t cost much but adds a lot of token buyers. This is in contrast to the stock market where such exaggeration will incur some penalty or market correction in the prices.
Bitcoin educator Jimmy Song states in his blog “most coins in the industry have very high-risk profiles. Most of them have no hope of achieving what they purport in their marketing story. Most have no track record of delivery and can be fairly characterized as unresearched. If these were stocks, they’d be sent to the pink-sheet and have a very low price due to the risk premium.”
Bitcoin, on the other hand, is developed without any marketing stunts and is today, the most decentralized cryptocurrency present. This means Bitcoin at its creation did not have perverse incentives, whereas altcoins at their creation did. Third, Bitcoin has the largest market cap value which makes it the most traded cryptocurrency even today. This brings our concern to the cryptos which are born out of Bitcoin, the forks of Bitcoin. Litecoin, Bitcoin Cash, Bitcoin SV, and others are essentially small tweaks to the Bitcoin codebase. The case against including forked altcoins is simply that the quality is worse and that there’s no risk reduction. In other words, these coins can fairly be characterized as “worse” Bitcoins which don’t add the desired properties of risk reduction and volatility reduction to a portfolio. Considering both the factors (correlation and codebase), the sole intent of diversifying the portfolio or buying another altcoin using Bitcoin shall be to increase the value of your portfolio in Bitcoins. The altcoins are volatile and their market triggering incidents can help an investor increase the amount of Bitcoin they own. Stable coins can assist investors to hedge against the Bitcoin’s price plunges, but otherwise, the question in the heading of this blog should make investors ponder before they employ any diversification strategy.