7 Ways To Diversify Your Investment Portfolio
A crypto investment portfolio comprises digital assets known for their volatility and reliance on market fundamentals, making them high-risk. To maximize returns and minimize risk, it’s crucial to strike a balance and diversify your portfolio.
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Before constructing their own portfolio, investors should research and familiarize themselves with the various asset types in the cryptocurrency market. They should also identify the key parameters and characteristics of each:
- value (assessing market demand and investor interest);
- liquidity (the more trading volume and available platforms, the better);
- decentralization (the less centralized the cryptocurrency, the better);
- risk level.
While illiquid assets might occasionally exhibit solid growth, if they're traded on just one or two small exchanges, selling them at peak value can be challenging. As a result, it's generally unwise to invest in such assets.
Asset classes
There are two primary categories: Bitcoin and altcoins. Bitcoin holds the title of the most liquid asset, boasting a market share exceeding 47%. Among the altcoins, Ether takes the lead with a market share surpassing 19%. These two digital assets dominate the market, found on all trading platforms, and are widely regarded as the most liquid and least risky options.
All remaining altcoins fall into nearly 60 different classes based on their functional purposes, such as stablecoins, NFTs, Web3, DeFi market assets, P2E, DAOs, meme tokens, AI tokens, and more.
To gauge an asset's worth, investors need to comprehend the class of cryptocurrency and its intended function. A thorough analysis of the asset across all characteristics is essential for making the ultimate decision on whether to include it in one's portfolio.
Risk tiers
Bitcoin is considered the least risky and most decentralized asset. Its low-risk nature stems from the utilization of the Proof-of-Work consensus algorithm and the inherent mechanism designed to thwart attempts at monopolizing control or launching attacks on the blockchain. Decentralized anonymous cryptocurrencies, like Monero and similar ones, also exhibit low-risk profiles. In contrast, other assets carry higher risks. For instance, Ether has garnered a negative reputation due to pre-mining (signifying high levels of asset centralization in the hands of a specific group of holders) and a considerable number of dubious quality tokens issued within the Ethereum network. Stablecoins occasionally face regulatory challenges, while DeFi market assets are deemed the riskiest of all.
Crypto investors must identify which assets from each class are worth adding to their portfolios based on risk levels while determining the appropriate quantity and percentage allocation.
Set aside a portion in a reserve fund
Aside from buying volatile assets to profit from market movements, it's advisable to keep up to 25% of your capital in stablecoins (e.g., USDT, USDC, DAI). These coins are stable and well-suited for market speculation. They can be utilized during market dips or downtrends to purchase volatile cryptocurrencies at a significant discount.
An example of an investment portfolio could look like this:
- 40% – Bitcoin (BTC);
- 20% – Stablecoins;
- 20% – Liquid cryptocurrencies with substantial market capitalization (ranked 1-50 on CoinMarketCap);
- 10% – Cryptocurrencies with medium capitalization (ranked 50-200 on CoinMarketCap);
- 10% – High-risk assets.
It's important to emphasize that this is not a recommendation but merely an illustration. Aggressive investment portfolios might contain a considerably larger percentage of high-risk assets and different allocations. Ultimately, the choices depend on each investor's preferences, goals, and market expectations.
Don't put all your eggs in one basket
It's wise to avoid storing all assets in a single location. If an investor intends not just to passively hold assets (employing a “Buy&Hold” strategy) but also to earn profits from speculative transactions (trading), it's recommended to divide the majority of the investment portfolio into 2–4 parts. These should be held on major exchanges such as Binance, WhiteBIT, OKX, Huobi, and others. A smaller portion (the reserve fund) should be kept in cold wallets, where profits from trading operations can also be withdrawn.
Assessing portfolio performance
The efficiency of a formed portfolio can be gauged using the Sharpe ratio. It shows the degree of excess average returns of a portfolio over the risk-free rate of return per unit of volatility. Simply put, the higher the quality and profitability of assets in the portfolio, the greater the Sharpe ratio will be.
Optimal values are considered to be between 1.5 and 2. If the Sharpe ratio falls within the 2-3 range, this suggests that the portfolio is well-balanced in terms of returns and risk levels. A value above 3 indicates that the investment portfolio has excellent diversification metrics. The Sharpe ratio can also be employed to evaluate individual assets.
Determining the risk coefficient (degree of diversification) for the portfolio
Similarly, the portfolio's risk level can be assessed. The Beta coefficient is used for this purpose. Acceptable values for the Beta coefficient are 1, but the closer it gets to 0, the better. This coefficient can also be utilized to gauge the risk associated with each separate asset.
Rebalancing the investment portfolio
It's important not to neglect the rebalancing of your asset portfolio. This operation should be carried out at least once a year or even more frequently if possible. We have dedicated a separate article to cover this topic in more detail.
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