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With the unpredictable nature of the digital asset markets, diversification of crypto portfolios is becoming increasingly crucial. What is it, and how can you diversify your cryptocurrency holdings?
One of the most challenging decisions that crypto investors must make is how to organize their portfolios. Given the high volatility of stock values, which may range from -30 percent to +30 percent in a single day, how can a portfolio be structured to reduce Risk while maximizing profit?
Systematic and unsystematic Risk
Let’s take a look at the concept of Risk for a moment. A token, like a portfolio, is exposed to two forms of Risk. There are two types of Risk: systematic Risk & unsystematic Risk.
Unsystematic Risk is a particular risk to the token, such as management, product lines, legislation, etc. This is the sort of Risk that a portfolio may diversify away.
On the other hand, systematic Risk is a type of market risk present in all tokens on the market and hence cannot be diversified out of a portfolio.
Because there are many systematic Risk in crypto, we want to diverify as much of the unsystematic Risk as possible. This may be accomplished by diversifying your cryptocurrency holdings.
So, what percentage of one’s portfolio should be invested in cryptocurrency to reduce unsystematic Risk?
There was a clear answer a long time ago: not more than 1–3%.
Now that institutions, large corporations, and well-known brands have gone into crypto, it’s time to increase the bar to 10%.
At this point, I would even suggest that the Risk of Crypto is nearly identical to that of commodities and the stock market. People have begun to regard online commodities the same way they do physical items, and this tendency is only expected to grow shortly.
However, remember that cryptocurrency is a high-risk asset, which will plummet the most in an emergency.
Various crypto allocation ideas
Cathie Wood, Ark Invest, believes bitcoin and other cryptocurrencies will become a standard element of suggested portfolios for investors.
She believes that cryptocurrencies, such as bitcoin, will resemble bonds in the future. As a result, she predicts that the bond components of these portfolio allocations may eventually be phased out in favor of cryptocurrencies.
“You think of the conventional 60/40 stock-bond portfolio, but look at what’s going on with bonds right now,” she explained. “That asset class has done its job if we are concluding a 40-year secular drop in interest rates. So, what’s next? Crypto, we believe, may be the answer.”
Another allocation idea comes from Yale economist Aleh Tsyvinski’s research.
Despite their increased volatility, cryptocurrencies, according to the study, have a more significant potential return than other asset classes.
Even bitcoin doubters should expect at least a 4% bitcoin allocation, according to the report. Those wary of cryptocurrencies should include at least 1% in their portfolio, if only for diversification’s sake.
Why Is Diversification of Cryptocurrency Portfolios Important?
Unlike most traditional assets, the market for digital assets is highly volatile. Several times a day, prices might abruptly move in various directions to the benefit or cost of investors.
As a result, while volatility tends to boost profitability, it also increases the Risk of losing money. It is not uncommon for the price of Bitcoin to decrease by 50% in a couple of days. Investors that are significantly involved in the Bitcoin market will see their portfolio value plummet in such circumstances.
Spreading one’s capital across various digital assets is recommended to reduce such levels of risk exposure. This investing approach helps to mitigate the size of losses experienced during market downturns. Because you just put a portion of your money in Bitcoin and spread the rest among various currencies, a 50% Bitcoin fall is unlikely to be as severe.
This is because the performance of the component crypto assets in a diversified portfolio would compensate for the losses.
The crypto market’s extreme volatility necessitates the use of effective risk management strategies. One of these techniques, as explained in this article, necessitates a dynamic approach to asset allocation. Portfolio diversification is an effective risk-mitigation strategy for crypto investments when done correctly.