How to diversify cryptocurrency portfolio?

Highlights

• Diversification of the crypto portfolio is similar to the diversification of traditional portfolios.
• With thousands of cryptocurrencies, it is a cumbersome task to choose the right currency for a portfolio.
• Choosing the right cryptocurrency becomes further complicated as the crypto market is highly volatile and the risk can be adjusted by including different crypto assets in the portfolio and regularly rebalancing it.

Bitcoins and Ethereum are the most popular cryptocurrency at present, but it does not mean that concentrating investor’s capital in these cryptos will generate higher returns. It is essential to construct a diversified crypto portfolio. 

Diversification of the crypto portfolio is similar to the diversification of traditional portfolios. That is, the investment is spread across the range of crypto assets. 

Presently, there are more than 3,000 cryptocurrencies, and it is a cumbersome task to choose the right currency for an investor’s portfolio.

Choosing the right cryptocurrency becomes further complicated as the crypto market is highly volatile. The risk can be adjusted by including different crypto assets in the portfolio and regularly rebalancing it.

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With that in mind, the present article discusses the categorise of cryptocurrencies, the technique for building the crypto portfolio and highlight the techniques which can be employed for diversifying the portfolio.

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What are the categories of cryptocurrencies?

It is suggested that a portfolio should be diversified across asset classes as it reduces the risk exposure. Cryptocurrency is an asset class, but for constructing a crypto portfolio, cryptocurrencies have been divided into categories on the basis of the major function they serve in the crypto market.

Payment coins – These coins deal with transferring the value from one entity to another entity. Earlier, the majority of the cryptocurrencies aimed at creating a network through which the value can be transferred. Bitcoins, Bitcoin Cash, Litecoin, Ripple are the most popular payment coins. After that, Ethereum was introduced, and concept of smart contracts evolved in the market.

Stablecoins – The value of stablecoins is tied with the value of precious metals or fiat money. For example, the USD coin is a cryptocurrency that pegs the value of the US dollar on a 1-to-1 basis. Similarly, PAX gold’s value is tied with the one ounce of gold stored in the reserves. Stablecoins’ main function is to provide stability. Movement in the crypto ecosystem does not affect the value of the stablecoins significantly. Moreover, the process of converting a coin into a stablecoin is fast, secure and easy.

Security tokens – These coins ensure that data privacy, security and safety are maintained. Privacy is a major component and might attract numerous investors. For example, Uniswap is a decentralised network that does not ask for the user’s data and transactions are conducted anonymously. Other examples are Zcash, and Monero.

Platform coins – These coins are traded on the centralised platforms and aims at resolving the issue that is associated with blockchain technology. For instance, DASH aims at solving the issue of digital payment in a different way. On NEM, smart assets can be constructed and on NEO, the smart contracts can be provided through programs.

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Governance coins – These coins provide the cryptocurrency holder with the power to participate in establishing rules for the network along with a share in the revenues. There are innumerable cryptocurrencies that extend the governance power such as SushiSwap, Uniswap, PancakeSwap.

Protocol coins – These coins are at the development stage and will get into the application soon. For example, BAT tokens, MaidSafe, IOTA and EOD.

How to build the crypto portfolio?

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The portfolio construction requires a lot of research, especially when the portfolio is constructed as per the personal risk tolerance and investment objectives. Therefore, the following steps can be undertaken while constructing a portfolio:

Keep track of the cryptocurrencies – Firstly, the investor needs to look for the cryptocurrencies that are available along with the values at which they are being traded.

Get updated knowledge – White papers are published by the cryptocurrencies and that can be used to assess the working of the currency and assess the future plan of the currency.

Use of the currency- analyse the use of the currency and ascertain its success in the long term.

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Assigning weightage to the assets – The portfolio should include low, medium and high-risk coins and appropriate weightage should be allocated. The weightage should be dependent upon the individual risk tolerance. It seems a good idea to put money in the high-risk coins because of the high reward, but the portfolio will not be termed as diversified.

Liquidity – To maintain the liquidity of the portfolio, it is essential that the stablecoins are included, as they can quickly exist their position.

Avoid overweight – While inducing capital, it is necessary to ensure that certain assets are not overweighted.

Stay updated with the market – Since the crypto market is highly volatile it is essential that investors have all the information regarding the market and the factors that affect it. The investment decision should be based on personal research as it is your money.

What approaches can be used while diversifying the crypto portfolio?

Use cases of crypto – One of the approaches can be to include different types of cryptocurrencies in the portfolio. For example, a portfolio might include all types of coins like protocol coins, security coins and so on.

Time diversification – It stands for making small investments for a longer period of time and on a continuous basis. For instance, a cryptocurrency is bought in month 1, and then 2^nd in the next month. At the end of the investment, a crypto portfolio will be created.

Geographical diversification – It stands for making investments in the currencies that are created in different parts of the world.

Bottom Line

Currently, there are more than 3000 cryptocurrencies, and it is difficult to choose the right cryptocurrency for the portfolio. Therefore, it is essential that investor conducts personal market research and afterwards build their cryptocurrency portfolio as per their risk and returns requirements.