Introduction
How many times do investors get told to diversify their holdings? Never put their eggs in one basket. It’s a fair point, but it is often applied incorrectly.
Diversification is a sound investment strategy and aims to do the following:
- Mitigate risk to withstand market volatility and uncertainty
- Optimise returns by getting exposure across potential opportunities.
However, there is one part of the equation that is so often forgotten: Correlation.
To all the crypto investors out there, how many of you have all your capital in crypto? You might not be as diversified as you think.
Risk Management
One goal of diversification is to protect ourselves from one of our baskets falling apart, so why do we forget that some of our baskets are made from the same stuff?
Consider cryptocurrencies. As the old saying goes, different strokes for different folks, but the tune remains the same. That is to say, whilst their specific movements vary, they ultimately follow the same patterns dictated by Bitcoin. Therefore, diversification doesn’t offer nearly as much risk mitigation as we might assume.
In other words, don’t go thinking you’re immune to a market collapse because you’ve ‘diversified’ your holdings across different cryptocurrencies. In bearish conditions, it would have been more pertinent to actually condense your holdings into USD.
So how do we really diversify to mitigate risk?
The key to diversification for risk mitigation is to do so across strategies that are less strongly correlated which typically requires other asset classes. The easiest comparison would be stocks and Bitcoin.
Whilst they both saw downside movement in recent times, the movements were less violent with stocks.
Remember that the main goal of risk management is psychology. Watching your entire portfolio collapse because it’s exclusively in crypto takes a significantly larger mental toll than if that drop was padded by being diversified across stocks that took a less violent hit. Other asset classes to be considered include bonds, real estate, commodities etc.
Portfolio Growth
On the other side of the coin, diversification within a correlating asset class like cryptocurrencies serves more of a strategic benefit in portfolio growth for when conditions are more bullish.
What I mean by this is whilst Bitcoin will still ultimately dictate the movement of the market, there is potential for better growth in tokens that outpace Bitcoin and through diversification, we may gain exposure to these opportunities. This is especially pertinent when we consider that bull cycles come in waves (i.e. Bitcoin tends to move first, then high cap alts, then low cap alts) and the inevitably diminishing returns on increasing Bitcoin prices.
Let’s take the DeFi boom as an example. In the period highlighted, Bitcoin went from a price of approx. $32K USD to $60K USD which is an 87.5% increase. CAKE on the other hand went from around $1.15 to nearly $26 which is a 2160% increase.
Furthermore, if we were to look at the market cycles, the period where Bitcoin had more sideways price action saw Alts have their opportunity to run in what is often referred to as ‘Altseason’.
To be clear, this does not mean that we ape into altcoins looking for moonshots. It’s about how we can use diversification to potentially increase upside whilst also mitigating downside because finding moonshots is easier said than done and requires an understanding of where the current meta is.
What it means is we can construct strategies whereby Bitcoin might represent our lower risk holding in crypto since under bullish conditions it is typically the safest option for allocating capital. We can then have capital aside for higher risk plays where we search for those opportunities that may outpace Bitcoin.
Summary
To summarise:
We must first identify what the current conditions and our goals are. Is it a risk-off environment where we are looking to preserve capital? Or are we in bullish conditions and are looking for opportunities to grow our portfolio? What is our own risk appetite?
Risk management to reduce downside means diversifying across un-correlated assets which inevitably brings in different asset classes and requires a much broader look at portfolio constructions. In this case, correlation does not work in our favour.
Diversifying for portfolio growth means identifying high risk but high reward opportunities within an asset class to increase our chances of outpacing the benchmark of that class. In the case of crypto, we ideally want to outpace Bitcoin and correlation can work in our favour.