With the rise of cryptocurrency, many investors have joined the bandwagon of crypto funds in order to diversify their overall portfolio. The total cryptocurrency marketcap currently stands at $1.18 trillion at the time of writing thanks to major cryptocurrencies like Bitcoin. With so many investors turning towards cryptocurrency, learning how to further diversify the funds you invest into cryptocurrency can help mitigate more risk.
Cryptocurrency is a digital or virtual currency that uses cryptography for security and operates independently of a central bank. Cryptocurrencies are decentralized and use blockchain technology to record transactions and manage the issuance of new units. Bitcoin is the first and most well-known cryptocurrency, but there are now thousands of different cryptocurrencies in circulation, each with its own unique features and use cases.
What is Diversification?
Whether you are investing in cryptocurrency or other assets, diversification is key to reducing risk and optimizing returns. As a principle of investing, diversification means dividing investment funds among different types of, ideally, uncorrelated assets. This means that when one asset class takes a loss due to certain economic factors, the other asset classes you are invested in will hopefully not take the same hit.
Why Diversification is Needed?
Here are three significant reasons to opt for diversification.
1. Risk Mitigation
Diversification is one of the important aspects of investing, as it helps mitigate the risks associated with a concentrated portfolio. When investors put all investments into a single trade, they are more likely to expose themselves to a significant risk of loss in case of a downfall in that particular asset.
By diversifying across different crypto assets, investors can reduce the impact of market volatility on their portfolios. This is because different crypto assets often react differently to market changes, which means, losses in one area and gains in other trades could mitigate overall loss.
2. Lowering Volatility
Diversification also has the potential to reduce portfolio volatility. This is because when investors diversify their portfolios with different crypto assets, they are spreading their investments across multiple asset classes and sectors. As a result, the impact of any single mishap or market fluctuation is diluted across the entire portfolio.
By doing so, traders can ensure stable and predictable investment returns over time, which can help investors sustain negative impacts during periods of market turbulence.
3. Long-term Growth
Diversification of portfolios in the crypto space can also help investors to achieve long-term growth by taking advantage of a wide range of investment opportunities. When investors focus solely on one asset class or sector, they may miss out on potential gains in other areas of the market. However, by diversifying their portfolio, investors can tap into multiple growth opportunities, which can help to maximize returns over the long run.
Benefits of Diversification
When choosing how to diversify your assets, there are a number of key benefits to keep in
1. Risk Mitigation:
Diversification is a useful tool to manage risk by spreading investments across multiple assets or markets. By doing so, the negative impact of underperformance in one specific cryptocurrency can be reduced, and the potential for large losses can be minimized. Essentially, diversification is an effective strategy to mitigate risk.
2. Unlocks New Opportunity:
By investing in a diverse range of cryptocurrencies or ETFs unlocks a myriad of investment opportunities for you to capitalize on. As every cryptocurrency offers different features and benefits, can diversified portfolio ensures one can take advantage of these opportunities.
3. Improve Liquidity:
Expanding the variety of assets in your investment portfolio can enhance your ability to convert them into cash quickly. This is because having a substantial portion of your investments in one cryptocurrency that has limited market demand or is not easily tradable could hinder your ability to sell it.
Also Read: Crypto Spot Trading vs. Margin Trading – What is the Difference?
Drawbacks of Diversification
While diversification is a great way to protect your assets and overall financial standpoint, there are a few drawbacks to keep in mind when allocating funds:
1. Over-diversification:
Investing in too many cryptocurrencies can lead to over-diversification, which can dilute the potential gains of your portfolio. It can also make it challenging to keep track of your investments.
2. Increased Complexity:
Managing a diversified cryptocurrency portfolio can be complex and time-consuming, especially if you are not familiar with the various cryptocurrencies and their underlying technology.
3. Higher Fees and Transaction Costs:
As you invest in more cryptocurrencies, you may incur higher fees and transaction costs, which can eat into your investment returns. Also, traders from countries like India, where heavy tax levies on crypto trading can reduce profit margins.
Also Read: Demystifying Crypto Taxes in India: What You Need to Know
4. Volatility:
Cryptocurrencies are known for their high volatility, and diversifying your portfolio may not necessarily protect you from market fluctuations. In some cases, diversification may even increase your exposure to volatility if you invest in riskier cryptocurrencies.
5. Lack of Regulation:
The cryptocurrency market is largely unregulated, which means that there is a higher risk of fraud, hacking, and other security issues. Diversifying your portfolio across multiple cryptocurrencies can increase your exposure to these risks.
How to Diversify Cryptocurrency Investments
As you start to deepen your cryptocurrency portfolio and consider strategies for earning significant returns in the crypto market, there are a few diversification principles you must follow:
1. Invest in a Crypto ETF
Cryptocurrency ETFs (exchange traded funds) are a new form of cryptocurrency investing that are still being developed. These funds work in the exact same way as a normal stock ETF in that an investor puts funds into the ETF which diversifies pooled investor funds across a number of different assets. This allows an investor to gain exposure to multiple types of cryptocurrency by only investing their money in one place.
2. Diversify which Crypto Industries you Invest in
Similar to stocks, cryptocurrencies often correlate with certain industries based on their use cases. You should aim to invest in cryptocurrencies that represent different industries so that if one industry suffers financial ruin, your other cryptocurrency investments can offset the losses.
3. Invest in Cryptocurrencies with different use Cases
As mentioned briefly above, most cryptocurrencies have a use case as their foundation. Nowadays, solar companies, blockchain development firms, and more have all released cryptocurrencies based on their product. If you believe some of these products to have strong growth potential, then investing in the cryptocurrency that backs them could help you diversify.
4. Divide up your Investments based on Risk Level
While all cryptocurrencies are volatile, some tend to have more price fluctuations than others. Divide up your cryptocurrency investments across different risk levels so that the fluctuations of one cryptocurrency do not affect another.
5. Reconsider the Liquidity of each Cryptocurrency before Investing
Liquidity refers to how easily an asset can be bought or sold without affecting its price. It’s important to consider the liquidity of each cryptocurrency before investing, as illiquid cryptocurrencies can be challenging to sell and may result in significant losses. Therefore, diversifying our portfolio with liquid cryptocurrencies that have a high trading volume can help you reduce the risk of being stuck with an illiquid asset.
The Bottom Line
As crypto is a highly volatile asset that is still in its infancy and there’s still a lot of uncertainty playing around it. By keeping this in mind, investors must have to reconsider their risk appetite to achieve long-term profits. Use the above tactics to diversify your overall cryptocurrency portfolio to reduce risk but be aware that not all risks will be mitigated. When investing in assets such as cryptocurrency, all investors need to be willing to accept the inherent uncertainty that comes with such an investment.
