Explained: Crypto Asset Allocation and Diversification
In conclusion, developing a well-balanced crypto portfolio can help you reduce volatility risks and enjoy greater predictability. This article will teach you the best methods for obtaining crypto diversification.
Here are three words to remember if you want to be a successful investor: diversify, diversify, and diversify.
Diversification is a key investment idea that helps lower risk by exposing a portfolio to many different types of assets.
When it comes to crypto investing, spreading your investments across multiple digital currencies makes sense because it can help to reduce portfolio volatility.
Diversification, on the other hand, can be done in many different ways, and asset allocation is what determines the best mix of assets when building an investment portfolio.
The goal of crypto asset allocation is to balance the risk/reward ratio in your portfolio by adjusting the percentage of each crypto asset in your portfolio based on your medium-to long-term goals and risk tolerance.
Let’s take a look at some allocation and diversification strategies for balancing risk and reward in your crypto investments for the best long-term performance.
There are bitcoin maximalists, Ethereum believers, DeFi (Decentralized Finance) supporters, and so on. Even if you have a preference for one type of crypto asset over another, it is best to be agnostic when it comes to crypto investments so that you can spread your money around.
Understanding the different types of crypto assets will let you know if you might be holding two or more assets that are similar in some ways and might behave the same way in some situations.
Cryptocurrencies are virtual currencies that rely on their own blockchains. Bitcoin (BTC) is the most popular cryptocurrency and stands alone. Altcoins, or alternatives to bitcoin, include Litecoin (LTC), Monero (XMR), and bitcoin clones like Bitcoin Cash (BCH) and Dogecoin (DOGE).
Smart Contract Platforms: These are the blockchain’s base layer, or “Layer 1” operating systems, on which other crypto applications can be built. With its ERC-20 standard, Ethereum is the market leader in this category, but there are many others, including Cardano (ADA), BNB Chain (BNB), and Solana (SOL).
DeFi: Decentralized Finance is one of the most successful uses of blockchain technology. Most DeFi projects, like Uniswap (UNI), Aave (AAVE), Compound (COMP), Yearn Finance (YFI), and Balancer, issue their own tokens (BAL).
Stablecoins are tokens whose prices are tied to fiat money (typically the US dollar), commodities (such as gold), or other real-world assets. Stablecoins’ goal is to provide a safe place for crypto investors to store their money while also acting as a link between the crypto and traditional economies.
NFTs (non-fungible tokens): These investments are usually one-of-a-kind and represent something irreplaceable. While you wouldn’t mind if your bitcoin was replaced with another, each NFT has its own unique identity (and selling price). NFTs can stand for digital or physical things, like artworks, expensive goods, or intellectual property.
While this list is slightly condensed from the DACS, there are other ways to slice the pie, such as by market capitalization (large-cap coins vs. mid-cap coins), consensus algorithm (Proof of Work vs. Proof of Stake), infrastructure (Layer 1 vs. Layer 2), sector (DeFi, gaming, metaverse), and so on.
Diversification means building a crypto portfolio with exposure to all kinds of crypto assets, ideally the long-term leader in each category.
Asset Allocation Types
Because crypto assets are still in their early stages, most investment and analysis practices have been borrowed from traditional markets. One of the most important mathematical frameworks for building an investment portfolio (MPT) is the Modern Portfolio Theory.
The MPT was made by Harry Markowitz 70 years ago, and he got the Nobel Prize in Economics for it. It helps investors get the most money for a given level of risk.
The main assumption of MPT is that investors are naturally risk averse. As a result, if two portfolios offer the same expected return, investors will choose the less risky option. As a result, it makes sense to increase risk only when motivated by higher expected returns.
According to the MPT logic, combining uncorrelated crypto assets can reduce portfolio volatility. This should also improve risk-adjusted performance, which means that a portfolio with the same amount of risk will earn more money with the same amount of risk.
Because the MPT is about traditional finance, a typical asset allocation framework says that asset classes can be either traditional (like cash, stocks, and bonds) or alternative (like commodities, real estate, derivatives, and crypto assets).
We can apply the same logic to cryptocurrencies: traditional assets may include bitcoin, Ethereum, and well-established stablecoins, whereas alternative assets may include more volatile tokens such as DeFi, Metaverse, NFTs, and so on.
There are two main approaches to building a crypto portfolio within MPT:
Strategic Asset Allocation (SAA) is a tried-and-true “set it and forget it” strategy. You won’t be looking for rallies in search of returns here. Instead, the goal is to create and maintain a well-balanced portfolio with an appropriate mix of crypto assets to help you achieve your long-term goals. SAA portfolios should be rebalanced only if your time horizon or risk profile changes.
Tactical Asset Allocation (TAA): TAA is appropriate for more active investors. It allows investors to focus their portfolios on cryptocurrency assets that outperform the market, such as DeFi tokens. TAA believes that if a sector outperforms the overall market, it may do so for an extended period of time. (Of course, the trick is “market timing,” which is difficult to achieve.)
While SAA and TAA principles can be applied to a crypto portfolio, the crypto market is ultimately correlated to the price of bitcoin, making diversification more difficult. However, some tokens, such as those associated with DeFi, may have a lower correlation
Examples of Diversified Crypto Portfolios
So, what constitutes a well-balanced crypto portfolio? Here are a couple of examples:
Conservative: Those who prefer the SAA approach may want to consider the 80/20 rule, which states that 80% of your crypto portfolio should be allocated to large-cap tokens (market caps greater than $10 billion) and 20% to small-cap tokens. As an example:
BTC: 30% (large cap) (large cap)
ETH: 30% (large cap) (large cap)
ADA: 5% (large cap) (large cap)
XRP: 5% (large cap) (large cap)
SOL: 5% (large cap) (large cap)
BNB: 5% (large cap) (large cap)
AVAXL: 5% (small cap)
MATIC: 5% (small cap)
LINK: 5% (small cap) (small cap)
FTM: 5% (small cap)
Balanced: If you prefer a more balanced investment with a higher risk-reward profile, consider the 40/30/30 rule, in which 40% goes to Bitcoin and Ethereum (whether 20/20 or 30/10), 30% goes to large caps (market caps greater than $10 billion), and 30% goes to mid-caps and small caps.
BTC: 20% (large cap) (large cap)
ETH: 20% (large cap) (large cap)
ADA: 10% (mid cap) (mid cap)
XRP: 10% (mid cap) (mid cap)
SOL: 10% (mid cap) (mid cap)
ATOM: 5% (small cap) (small cap)
AVAX: 5% (small cap) (small cap)
MATIC: 5% (small cap)
LINK: 5% (small cap) (small cap)
FTM: 5% (small cap) (small cap)
UNI: 5% (small cap) (small cap)
Adding Diversification to Your Crypto Portfolio (Balanced)
Keep in mind, though, that both of these strategies should be part of a larger portfolio of high-quality stocks and bonds.
See our Blockchain Believers Portfolio for an example, where crypto accounts for no more than 10% of the portfolio. The above percentages would apply to that 10% piece of the pie.
Increasing the Diversification of Your Overall Portfolio…
Divide your cryptocurrency portfolio into high, medium, and low-risk investments. Then, do the same for your overall portfolio, keeping in mind that, with the exception of stablecoins, most crypto is high-risk.
Feel free to keep some stablecoins (preferably USDC and USDT) in your crypto portfolio to help provide liquidity. Stablecoins allow you to quickly take profits or exit a position to avoid losses.
Rebalance your portfolio on a regular basis (we recommend taking a fresh look on two days that are easy to remember, like January 1 and July 4).
Avoid overweighting any part of your portfolio when allocating new capital. If you’ve gotten good returns from small caps, don’t increase your stake in them; instead, stick to your original strategy of maintaining a balanced portfolio.
Most importantly, do your homework and invest only in what you understand and can afford to lose. It’s crypto, so be ready for anything.
The Takeaway for Investors
To repeat ourselves, diversify, diversify, and diversify.
Because crypto assets are extremely volatile, diversification is a great way to protect yourself from risk while reaping the benefits.
Diversify your cryptocurrency portfolio by including tokens with varying risk profiles.
Invest in high-quality stocks and bonds, and put no more than 10% of your money into cryptocurrency. This will help you spread out your risk.
Don’t put all of your eggs in one basket.