Risk management and diversification of an investment portfolio are fundamental to the success of your financial operations. Even though the crypto market is still relatively young, diversifying your portfolio can be a crucial aspect in winning the battle and being part of the small percentage of investors who make real profits. What are the necessary steps to diversifying your investment portfolio and what impact can including cryptocurrency make?
Diversification: An Essential Tool for Balancing the Risk of Investment
Experts agree that diversification is absolutely essential for investors who want to maximise gains from their trades and holdings; from those with a long-term perspective to those who engage in “day-trading” (trading financial assets in a single daily session).
Fidelity, one of the most important and recognized financial institutions in the world, confirms this premise. In an article on the official website, they define the concept of diversification as the “practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.”
Diversifying a portfolio of crypt coins
The introduction of cryptocurrencies has allowed many people outside this space to show interest and even decide to invest. In the strict sense of the concept, diversification refers precisely to the addition of different types of assets in an investment portfolio. However, many digital currency investors have only considered the leading Bitcoin and one or two other popular altcoins. Certain crypto exchanges have opened the door to investment with minimal capital, in some cases below $10. Where the capital is very low, diversification loses its focus and so it is more viable to limit your portfolio to the least number of financial instruments.
Now, what is the best way to diversify with cryptocurrencies? There’s no one right answer. A portfolio could be composed solely of cryptocurrencies. If this is the case, the investor has an implicitly high-risk profile. In other words, they are willing to lose more capital in the hope of making more profit. This is due to the volatile nature of the vast majority of cryptocurrencies. However, diversification does not lose its validity in this area. In fact, some currencies are more stable than others and it is still possible to diversify within the same typical parameters.
Evaluate the volatility of your favourite crypto assets
If your decision is to keep only crypto assets in your portfolio, you must have an unintuitive idea of how stable they are in price. Although the price of Bitcoin moves violently, Nakamoto’s is in fact one of the most stable assets in the industry. Other smaller altcoins register even faster and larger changes. For example, Cardano reports 5 times more volatility than BTC in the last 3 months according to the analysis website “Crypto Volatile”, which calculates the volatility index according to price evolution.
In addition to consulting this website, it is important to take into account factors such as market capitalization (CoinMarketCap). In general terms, this metric is inversely proportional to volatility; a very small capitalization makes the asset more susceptible to volatile movements in price. Technical analysis will also help define the level of volatility and provide information on trends and target levels.
Determine your risk profile
The decision on how to distribute the investment capital will essentially depend on the risk profile of the investor. In general, conservative investors fill more than 80% of their portfolio with more stable assets, thus reducing their possibility of losses, but also of gains. Conversely, aggressive investors allocate more than 85% of their portfolio to volatile assets with potential price changes. Either way, we suggest limiting the number of assets in your portfolio, ensuring that you will be able to track and monitor every open position. Each trade must have, among other things, a correct risk management.
Cryptocurrencies as part of an investment portfolio
However, in order to achieve real diversification, the addition of other types of financial instruments will need to be assessed. According to the quoted Fidelity article, this is essential to “balance risk and reward in your investment portfolio“. They also recommend distributing investment assets into different classes or categories.
For this type of trading, the recommendation is to use a regulated broker or platform. In addition to providing regulation, they usually offer a wider range of instruments to invest in. eToro is a good example of a platform that combines traditional assets with cryptocurrencies, but there are also other well-known brokers.