Diversification 101: Understanding this risk management essential
If you took a poll of traders, we bet most would agree that diversification is fundamental to effective risk management. Building a portfolio of highly diversified assets allows traders to manage their appetite for risk as they seek the highest return on their funds.
It's trading best practice 101, and in the spirit of not forgetting the fundamentals, let's remind ourselves of what diversification is, why it's important, and if the same rules apply to crypto. 👇
What is diversification?
Diversification is also known as asset allocation because it involves a trader allocating their pool of funds to several different asset types. Today, that could mean building a portfolio including stocks, bonds, and crypto. The diversification strategy a trader adopts is often guided by a number of factors:
- Their appetite for risk, which dictates the depth of their diversification and the specific assets chosen.
- The financial goals they want to reach through their portfolio. That could be saving for retirement, their child’s education, or possibly, a yacht.
- The time horizon they want to hold their positions across, which is often dictated by their financial goals.
Why do traders diversify their portfolio?
The main goal from diversification is to minimize exposure to one specific asset class and therefore reduce the volatility of the portfolio over time. It’s therefore not about maximizing returns, but minimizing risk.
For example, allocating your entire portfolio to stocks in fossil fuel companies might at one time have brought healthy returns. But today, the decline in demand for oil and shift towards renewable energy can create volatility among these stocks and therefore your hypothetical undiversified portfolio.
This leads us nicely to the important topic of correlation.
When considering asset allocation, traders will usually look at assets with low correlation. The price of assets with low correlation typically move independent of each other, because they’re not affected in the same way by a single event that impacts the market. As a result, a diverse portfolio of assets with low correlation is typically resilient to the inevitable fluctuations of markets. Where one asset may fall in value because of an external factor, the others remain unaffected.
Can diversification be applied in crypto trading?
The same theories on diversification and its benefits can apply to trading crypto coins and tokens, even though crypto is a single asset class. Arguably, diversification is especially important when trading crypto. That’s because regulatory pressure, media hype, token supply and demand, and public opinion all bring more volatility to the space when compared to other asset classes.
So, how do you diversify across your crypto portfolio? As with any asset class, by weighting your allocation of funds broadly. The difference is, with crypto diversification, it’s necessary to look one layer deeper than just the asset class. Here are just a few examples.
💲Crypto use case: It can be effective to diversity your crypto portfolio based on the underlying purpose of coins and tokens. With so many coins and tokens on the market, there’s no shortage of options. This allows traders to do their due diligence and decide which assets have the brightest future based on their purpose and expected market growth, and trade accordingly.
For example, BTC represents a digital currency for purchasing goods and services, while XRP supports the transfer of funds across borders with greater speed and lower cost. Meanwhile, non-fungible tokens signify the ownership of items through tokenization. Traders must decide which opportunity is worth a stake in.
🏗 Industry: Diversification can also be achieved by owning cryptocurrencies based on the industry they’re used in. Cryptocurrencies and their related blockchain technologies are increasingly being adopted across various sectors to bring added security, transparency, and efficiency to how organizations operate. Real estate, transportation, healthcare, entertainment, and many other sectors all offer opportunities for traders to gain exposure to crypto as an asset class through the real-world application of coins, tokens, and related technology.
📈 Market capitalization: Market capitalization is one other opportunity for crypto diversification that can allow for the balance of risk and reward. The market capitalization of a coin is calculated by dividing the total number of coins in circulation by the price one coin is currently trading at. As a general rule — but certainly not a concrete rule — coins with a large market cap are more stable than those with a mid or small cap.
As a result, coins with a large market cap (such as BTC, ETH, USDT) are often seen as a more conservative and therefore ‘safer’ option among traders. So, what of coins with a small and mid market cap? Traders often see small cap coins as presenting higher risk but also having the potential for sudden and meteoric growth, if the underlying project is promising. Mid cap coins, meanwhile, can perform strongly in the mid to long-term should the market grow. The key, as always, is to learn about and understand any coin and its underlying utility before deciding whether to trade it or not, regardless of market cap.
The bottom line
Portfolio diversification is considered a fundamental tactic in smart risk management for all types of traders. It can be an effective way to gain exposure to the fast-changing crypto space while reducing the impact of volatility on the market.
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