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Cryptocurrency investment can be seen as a mixture of investing and gambling. Many investors, like Mark Farfan, approach it as a long-term strategy and only invest what they are comfortable losing. While Farfan holds 80% of his crypto portfolio in established coins like Bitcoin and Ethereum, he also diversifies by investing in smaller coins such as Cardano, Litecoin, and Stellar. Farfan believes that the more coins he invests in, the higher the chances of finding one that takes off. However, he acknowledges that luck plays a significant role in crypto investing.
The Benefits of Crypto Diversification
Diversification in cryptocurrency investing serves two main purposes. First, it provides a portfolio with non-correlated assets, meaning that when some investments decline in value, others may hold steady or even rise. Second, diversification protects investors from catastrophic losses if one investment fails.
However, diversifying a crypto portfolio is different from diversifying a traditional portfolio of stocks and bonds. In the crypto market, all digital coins are highly correlated, meaning they tend to rise and fall together. This correlation limits the effectiveness of diversification in terms of reducing risk. Nonetheless, diversification can still help limit extreme outcomes. If one cryptocurrency fails and becomes worthless, other investments in the portfolio may still perform well.
It is important to note that diversifying a crypto portfolio does not guarantee higher returns. While it may limit potential losses, it can also limit potential gains. Owning multiple coins improves the chances of a successful investment, but it may also reduce the chances of hitting a massive jackpot.
Investing in smaller projects and coins that are integral to the decentralized finance (DeFi) ecosystem can be a profitable strategy. DeFi refers to a form of finance that operates without the need for intermediaries like banks or governments. However, investing in DeFi comes with risks, as the sector is susceptible to hacks and fraud.
Limits of Crypto Diversification
The correlation between cryptocurrencies poses a challenge to the effectiveness of diversification. When influential figures like Elon Musk make market-moving statements about Bitcoin, the prices of other cryptocurrencies often follow suit. The reasons behind this correlation are not entirely clear, but it could be due to the overlap in investor sentiment and the shared challenges facing the crypto market as a whole.
Given the correlation between cryptocurrencies, diversification within the crypto market alone may not provide sufficient risk mitigation. It is crucial to have a well-diversified portfolio that includes a mix of stocks, bonds, and other traditional assets. The allocation to each asset class will vary based on an individual’s financial situation, goals, and risk tolerance. Financial advisors generally recommend keeping investments in risky assets, such as cryptocurrencies, to a maximum of 2% to 5% of the total portfolio.
How to Diversify Your Crypto Portfolio
When diversifying a crypto portfolio, it is essential to start with established coins that have proven themselves to be legitimate and not scams. Bitcoin and Ethereum should make up a significant portion of the portfolio, with other promising coins and tokens filling the remainder. Greg King, CEO of Osprey Funds, suggests that Bitcoin and Ethereum should comprise at least half of an investor’s crypto holdings.
For investors who are less familiar with the crypto space, it is advisable to stick with well-established coins. Websites like Coindesk provide information about each coin, including market capitalization and additional details.
The number of coins to include in a portfolio depends on the investor’s risk tolerance and investment strategy. Investing in smaller coins may require a larger number of holdings to spread the risk. For those concerned about volatility, stablecoins backed by a reserve asset like the U.S. dollar or gold can offer a more stable investment option.
PieDAO, a platform that offers a range of crypto portfolios, suggests including a mix of coins and tokens in a diversified portfolio. Some portfolios may consist of only 5 to 6 coins, focusing on high-growth, early-stage DeFi projects. Others may include around 16 assets, including Bitcoin, Ethereum, and other established cryptocurrencies.
In conclusion, diversification is an important strategy in cryptocurrency investing, although its effectiveness is limited due to the high correlation among digital coins. Diversification can help limit extreme outcomes and protect against catastrophic losses. However, it is crucial to have a well-diversified portfolio that includes a mix of traditional assets alongside cryptocurrencies. Starting with established coins and gradually expanding into smaller projects can be a prudent approach to crypto diversification. Remember to invest only what you can afford to lose and consult with a financial advisor for personalized advice.
