Don’t put all your eggs in one basket. It’s the first word of advice you hear from a fellow investor. While confidence undoubtedly benefits investors (i.e., holding onto an asset despite volatility) there is nothing worse than being overzealous. Capital protection should be everyone’s number one goal, and the best way to stay safe and heighten your chances of survival is through diversification.
Diversification is a risk management strategy that exposes investors to multiple assets from different industries. It grants security by acting as a failsafe switch. If one asset from the portfolio drops in value, other assets might appreciate or remain stable and nullify the losses. Diversification also protects investors by preventing them from going all-in on an investment.
In the crypto market, diversification is accomplished by investing in projects from different ecosystems (or those that target different use-cases). Rather than allocating 100% of your capital into Bitcoin (store of value), Ethereum (smart contracts), or Ripple (payments), you may invest in all three projects to keep risk at bay.
Investors diversify cryptocurrency portfolios to:
Protect themselves against volatility and negative market swings
Decrease reliance on a project’s success
Increase the likelihood of earning more money
Identify and cut out losers in time to invest in high-performing projects
Why is Diversification Important?
Let’s say I’m exceptionally bullish on smart contracts and want to buy a cryptocurrency from a bullish SC ecosystem. I do some research and conclude that Ethereum reigns supreme, that it is technologically superior to its rivals, and that its first-mover status makes it unlikely to fail. I pull a few thousand dollars from my savings account, create a crypto wallet, and purchase ETH.
The following week I enter an Ethereum Discord server to chat with like-minded individuals. They further feed my delusion that I’d waste money by spending on other projects and that diversification is a meme.
I add .eth to my Twitter handle, follow all the famous Ethereum developers, and decide to double down on my investment. Someone convinces me that NFTs are leveraged investment vehicles and that I can accumulate more ETH by flipping them, so I buy a BAYC ape on Opensea.
One sunny morning, I wake to see what Crypto Twitter is up to. Everyone’s talking about how Ethereum failed and that another SC rival toppled it. My precious investment turns into dust as the community decides that Buterin’s project is no longer number one. The market starts a selling spree as investors liquidate their Ether holdings to invest in the other project, and my capital shrivels with each passing minute.
By that moment, months or even years had passed, and my time in crypto was wasted. If I had bought into two or three other projects, my portfolio may have avoided collapse. I applied zero risk management strategies and suffered the consequences.
Note that in this example the smart contract sector didn’t fail, the project did. I was right by betting my money on SC ecosystems, but I exposed myself to unnecessary risk by limiting my investment to one project. Again, don’t put all your eggs in one basket.
How to Diversify Your Crypto Portfolio
Crypto investors diversify portfolios by allocating capital into a mix of projects, which differ by ecosystem and use-case. The portfolio can contain as many assets as we want, but typically four to eight-asset portfolios perform the best.
When we create our first cryptocurrency portfolio, we want to make sure that the first and second crypto we select have nothing to do with each other. They should be polar opposites at best, and rivals at worst.
For example, if we buy an exciting new yield farming protocol from the DeFi segment, we can lower our risk by placing the next investment in a traditional crypto project with a longer standing like Bitcoin or Monero. Or if we do invest in yield farming, we should at least buy two rivaling projects so that we always come out on top. Maybe Yearn Finance offers the best yields now, but someday Compound might change the game and become number one.
When it comes to altcoins, we want to target more than one smart contract ecosystem. The following projects have the highest network activity:
From time to time, we observe an effect where investors rotate from one ecosystem to another. Whales start a bull run on AVAX, and investors jump onto the bandwagon to secure profits. Once the whales take profit they reinvest in Harmony.
The heightened activity on Harmony attracts investors previously committed to AVAX, who quickly buy ONE to purchase Harmony’s very own yield farming, lending, and P2E protocols. This is a great example of why we should abstain from maximalism and tunnel vision. Diversify to profit from the market at all times.
In recent years we have seen the rise of protocols that reward investors by providing passive income in return for liquidity. Formats such as yield farming, liquidity mining , and game theory-driven projects (3, 3) also offer long-term speculative value, but focus more on creating value on top of existing crypto capital through staking.
Some groups of investors who have already profited from the crypto market, or believe to have chosen a risk-free project, prefer to stake and refrain from daytrading. The existing level of APY rewards in the DeFi market provides extravagant profits to large holders.
Non-fungible tokens (NFTs) represent another venue for diversification. NFTs are denominated in the native token of the network on which they are based. And their mint price sets their initial value. For example, an NFT collection on Solana can start at 2 SOL per token. If SOL costs $150, then the NFT has a mint price of $300.
The following factors impact the NFT’s price:
Speculative value drives the prices of NFTs beyond their mint price. If investors believe that a collection provides sufficient utility or that it will be in high demand, a sizeable volume spike will drive the market floor up and the minimum value of each token within the collection. An NFT minted at two SOL can be sold for four, and the investor will double his money.
Investors can make money even if the NFT’s SOL value does not increase. If the price of SOL surges from $150 to $200 the NFT will be worth $400, netting a $100 profit. However, it is still possible for market floor prices to drop if the native token rises sharply.
Diversification is a risk management strategy that can’t save investors from a full-blown bear market. However, it can protect them against unnecessary risk in cases where assets lag behind, fail, or face selling pressure due to botched product launches.
By diversifying a portfolio, investors ensure that they have a backup plan if something goes wrong with their initial investment. Alternatively, it provides the opportunity to reinvest profits from high-performing projects into lagging ones by rebalancing their portfolio. It also helps with removing tunnel vision by forcing the investor to participate in multiple crypto ecosystems and networks.
About The Author:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.