Crypto Asset Allocation and Diversification, Explained

Summary: Building a well-balanced crypto portfolio can help you reduce volatility risks and enjoy more predictability. In this article, you will discover the best practices to obtain crypto diversification.


If you want to be a successful investor, here are three words: diversify, diversify, diversify.

Diversification is an important investment concept, helping to reduce a portfolio’s risk by getting exposure to multiple assets.

When it comes to crypto investing, the practice of spreading your investments across multiple digital currencies makes sense, as it can help to reduce the volatility of your portfolio.

That said, diversification can be achieved in different ways, and it is the job of asset allocation to find the best mix of assets when building an investment portfolio.

The goal of crypto asset allocation is to balance the risk/reward ratio by adjusting the percentage of each crypto asset in the portfolio based on your medium-term or long-term goals and risk tolerance.

Let’s look at a few allocation and diversification strategies to balance risk and reward for the best long-term performance of your crypto investments.

Different Classes of Crypto

There are bitcoin maximalists, Ethereum believers, DeFi (Decentralized Finance) enthusiasts – you name it. While you may prefer certain types of crypto assets, it’s better to be agnostic when it comes to crypto investing, so you can better diversify.

Understanding the different classes of crypto assets will make you aware of holding two or more assets that share the same characteristics and may perform the same way in certain conditions.

CoinDesk has put together a Digital Asset Classification Standard, which breaks out the top crypto assets into a few useful categories:

Cryptocurrencies: These are virtual currencies that rely on proprietary blockchains. Bitcoin (BTC) is the most popular cryptocurrency, and is in a class by itself. Examples of altcoins (or alternatives to bitcoin) are Litecoin (LTC), Monero (XMR), and bitcoin clones like Bitcoin Cash (BCH) and Dogecoin (DOGE).

Smart Contract Platforms: These are the base layer or “Layer 1” operating systems of blockchain, upon which other crypto applications can be built. Ethereum is the leader in this category, with its ERC-20 standard, but there are many others including Cardano (ADA), BNB Chain (BNB), and Solana (SOL).

DeFi: Decentralized Finance is one of the most successful use cases for blockchain technology, and most DeFi projects release their own tokens, including Uniswap (UNI), Aave (AAVE), Compound (COMP), Yearn Finance (YFI), and Balancer (BAL).

Stablecoins: These are tokens that have their price pegged to fiat money (usually the U.S. Dollar), commodities (such as gold), or other real-world assets. The goal of stablecoins is to create a safe place for crypto investors to store their money, while acting as a bridge between the crypto economy and traditional economies.

Non-fungible tokens (NFTs): These investments generally have unique value and represent something irreplaceable. While you wouldn’t care if your bitcoin was replaced with another one, each NFT has a distinct identity (and selling price). NFTs may represent digital or physical items, be it artworks, luxury goods or intellectual property.

While this list is slightly simplified from the DACS, there are other ways to slice the pie, including by market cap (large-cap coins vs. mid-cap), by consensus algorithm (Proof of Work vs. Proof of Stake), by infrastructure (Layer 1 vs. Layer 2), by sector (DeFi, gaming, metaverse), and so on.

The point of diversification is to build a crypto portfolio with exposure to all types of crypto assets — ideally the long-term leader in each category.

baby with healthy fruits
For a baby market like crypto, diversification is key.

Types of Asset Allocation

As crypto assets are still new, most investment and analysis practices are borrowed from traditional markets. For example, one of the most important mathematical frameworks for building an investment portfolio is the Modern Portfolio Theory (MPT).

The MPT, which was introduced by Harry Markowitz seven decades ago and for which he received the Nobel Prize in Economics, helps investors maximize returns for a given level of risk.

The main assumption of MPT is that investors are risk averse by nature. Therefore, if two portfolios offer the same expected return, investors would prefer the less risky one. Thus, it makes sense to take on increased risk only when motivated by higher expected returns.

As per the logic of the MPT, combining uncorrelated crypto assets can reduce the volatility of the portfolio. This should also improve the risk-adjusted performance, suggesting that a portfolio with the same amount of risk will yield better returns.

Since the MPT refers to traditional finance, a typical asset allocation framework suggests that asset classes can be divided into traditional assets (cash, stocks, and bonds) and alternative assets (commodities, real estate, derivatives, and crypto assets, among others).

We can borrow the same logic for cryptocurrencies: traditional assets might include bitcoin, Ethereum, and well-established stablecoins, while alternative assets could be more volatile tokens: DeFi, metaverse, NFTs, etc.

Within MPT, there are two main approaches to building a crypto portfolio:

Strategic Asset Allocation: SAA is a traditional “set it and forget it” approach. Here, you won’t be looking for rallies in a hunt for returns. Instead, the objective is to build and maintain a well-balanced portfolio with an appropriate mix of crypto assets to reach your goals over the long term. SAA portfolios need rebalancing only if there’s a change to your time horizon or risk profile.

Tactical Asset Allocation: TAA is suitable for more active investors. It enables investors to concentrate their portfolios on crypto assets that are outperforming the market, such as DeFi tokens. According to TAA, if a sector is outperforming the general market, it may continue to do so for an extended period of time. (Of course, the trick is “timing the market,” which is difficult to do.)

While the principles of SAA and TAA can apply to a crypto portfolio, the crypto market is ultimately correlated to the price of bitcoin, which makes diversification more challenging. Nevertheless, some tokens, such as those related to DeFi, may show a lower correlation.

bird houses

Examples of Diversified Crypto Portfolios

So what does a well-balanced crypto portfolio look like? Here are two examples:

Conservative: Those who prefer the SAA approach might consider the 80/20 rule, which assumes that 80% of your crypto portfolio is allocated to large-cap tokens (>$10 billion market cap), and 20% goes to small-cap tokens. For example:

  • BTC: 30% (large cap)
  • ETH: 30% (large cap)
  • ADA: 5% (large cap)
  • XRP: 5% (large cap)
  • SOL: 5% (large cap)
  • BNB: 5% (large cap)
  • AVAXL: 5% (small cap)
  • MATIC: 5% (small cap)
  • LINK: 5% (small cap)
  • FTM: 5% (small cap)

Balanced: If you prefer a more balanced investment but with a higher risk-reward profile, you may consider the 40/30/30 rule, in which 40% goes to Bitcoin and Ethereum (be it 20/20 or 30/10), 30% goes to large caps (>$10 billion market cap), and 30% goes to mid caps and small caps.

  • BTC: 20% (large cap)
  • ETH: 20% (large cap)
  • ADA: 10% (mid cap)
  • XRP: 10% (mid cap)
  • SOL: 10% (mid cap)
  • ATOM: 5% (small cap)
  • AVAX: 5% (small cap)
  • MATIC: 5% (small cap)
  • LINK: 5% (small cap)
  • FTM: 5% (small cap)
  • UNI: 5% (small cap)

Remember, however, that either of these strategies will ideally be diversified within an overall investment portfolio of high-quality stocks and bonds.

For an example, see our Blockchain Believers Portfolio, where crypto makes up a maximum of 10%. The percentages above would apply to that 10% slice of the pie.

Diversifying Your Own Crypto Portfolio

Each investor is unique, so you should bring your own preferences and ideas to your crypto portfolio. But here are some general guidelines for success:

Split your crypto portfolio between high, medium, and low-risk investments. Then do the same for your overall portfolio, noting that most crypto is high-risk, except for stablecoins.

Feel free to hold some stablecoins (preferably USDC and USDT) to help provide liquidity for your crypto portfolio. Thanks to stablecoins, you can quickly take profits or exit a position to avoid losses.

Rebalance your portfolio from time to time (we recommend taking a fresh look on two days that are easy to remember, like January 1 and July 4).

When allocating new capital, avoid overweighting any part of your portfolio. If you’ve managed to secure big returns from small caps, don’t increase your share in them but rather maintain the balanced approach according to your initial strategy.

Most importantly, do your due diligence and invest only in what you understand, and what you can afford to lose. It’s crypto: be prepared for anything.

Investor Takeaway

To repeat our three words: diversify, diversify, diversify.

Crypto assets are extremely volatile, which is why diversification is a great strategy to protect yourself from risk, while enjoying the rewards.

Diversify your crypto portfolio, by including different types of tokens with different risk profiles.

Diversify your overall portfolio, by investing in high-quality stocks and bonds, with a small slice of the pie (no more than 10%) devoted to crypto.

Don’t hold all your bags in one basket.

 

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This news is republished from another source. You can check the original article here.

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