Diversify your Crypto Portfolio Across these 5 Asset Classes
In this article we will look at 5 crypto asset classes with a brief introduction to diversification. Using back testing we will show the difference diversification can make to your crypto portfolio and why continually rebalancing is the key to maximizing returns and minimizing losses.
Crypto Asset Classes
"An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations."
Investors have been attempting to categorize assets for decades. And because cryptocurrency investing is relatively new territory, their classification and where each crypto belongs is still being determined by the community. Regardless, Bitomic has settled on 5 crypto asset classes that we feel best describe the various types of cryptos currently available (Currencies, Utilities, Securities, Platforms and Stablecoins). Read on for our definitions and examples of each.
Cryptocurrencies were originally invented as digital currencies, starting from the Bitcoin whitepaper proposing a "purely peer-to-peer version of electronic cash". Digital currencies function, as a medium of exchange, a store of value and a unit of account. Some examples of digital currencies are Bitcoin, Litecoin, and NavCoin.
Coins that give access to a product or service running over a blockchain such as computing power, storage capacity or bandwidth are called utilities. Their value increases as more people have a need for them and depending on supply and demand. Some examples include AppCoins, BAT, MaidSafeCoin and Augur.
Crypto securities are tied to physical assets or companies and they might provide dividends or interest payments to the holders. These types of crypto assets usually fall under financial regulators guidelines such as the securities and exchanges commission (SEC) in the U.S.
Designed as decentralized operating systems for other crypto projects, platforms allow developers to build applications (dApps) on top of it's network and use the network's token as gas for the applications transactions. As more projects are built on the platform and more transactions take place within those projects, the value of the platform increases. Some examples include Ethereum, Ripple and NEO.
"Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security."
Diversification is a popular strategy that can be summed up with the saying "don't put all your eggs in one basket". The hope is that by spreading your investments out across different asset classes, you won't be subject to large market swings as much as you would by being invested in a single crypto. Ideally when one drops in value, another would rise or at least hold it's value. To make the most of this strategy, you should carefully consider your time horizon and risk tolerance, continually rebalancing your portfolio as it changes over time.
Your time horizon is simply how long you are planning to manage your assets using a given strategy. The longer you can wait to cash out your investment, the longer your time horizon and hypothetically the more risky investments you can take on because you have more time to wait out large market swings. In the next section on back testing you will see how diversification works best over longer periods of time.
“To know thyself is the beginning of wisdom.”
Like everything in life, investing comes with risks. There is never a guarantee of returns and you could lose everything over night. With that said, some investments can be considered riskier than others. Risk tolerance is both a genetic and a learned trait and is up to the individual to understand how much risk tolerance they have. Getting involved in an investment that is riskier than you can handle can lead to sleepless nights, panic selling and worse.
As your basket of assets in your portfolio changes in value over time, you will need to rebalance. Bringing it back to the ratios you originally set. You can do this in one of two ways. On a fixed schedule (say at the end of each month) or when your portfolio gets out of balance over a predetermined threshold. Whichever way you choose, consistently rebalancing your portfolio helps to ensure the slow and steady growth you'd expect with such a strategy. See the difference rebalancing can make in the next section.
Crypto Diversification Back Testing
You might be wondering how much of an effect diversification can have on your crypto portfolio. Let's look at 4 different portfolios that each have a different mix of Currencies, Platforms and Utilities (Bitcoin, Ethereum, Ripple, NavCoin, Augur and MaidSafeCoin) and see how they performed over the course of 3 years. All were started at the same time with an initial investment of $1000.
Portfolio 1 (No diversification)
100% of Bitcoin. A simple portfolio showing no diversification at all.
After 3 years your portfolio would be worth $8937.48. Not bad but can we do better?
Portfolio 2 (Some diversification)
50% Bitcoin, 25% Ethereum and 25% Ripple, this portfolio introduces some diversity across crypto assets.
After 3 years your portfolio would be worth $19753.32. Already you are starting to see how diversification can help grow your investment.
Portfolio 3 (More diversification)
50% Bitcoin, 10% Ethereum , 10% Ripple, 10% NavCoin, 10% Augur and 10% MaidSafeCoin, this portfolio is our most diversified yet.
After 3 years your portfolio would be worth $18293.2. Not as good as portfolio 2 but still twice as good as our first portfolio.
Portfolio 4 (Diversified and Rebalanced)
Now let's introduce the missing ingredient, rebalancing. Using the crypto asset mix from portfolio 3, what happens when you rebalance every 12 months to maintain those ratios?
After 3 years your portfolio would be worth $38250.53. What happened here? At the height of a major upswing in the market this portfolio was automatically rebalanced with profits being redistributed to less volatile cryptos helping to keep some of those juicy profits.
In this article we have looked at 5 crypto asset classes, introduced diversification and shown how it can supercharge your crypto portfolio. There many strategies in investing, one of them being diversification. Whichever one you choose, it's always best to stick to a strategy and keep your emotions out of the equation.