Why It’s Important to Diversify Your Crypto Portfolio
October 11, 2022
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As the market continues to swing, we explore how diversification can help you reduce your risk and achieve your financial goals.
You’ve likely heard the old maxim “you shouldn’t put all your eggs in one basket”. Unsurprisingly, this also applies to your investments. If you’re planning to invest in crypto for the long-term, or if you just want to minimize losses, diversifying your portfolio should be at the top of your to-do list, regardless of your balance.
In this article, we’ll explain what diversification is, why it’s important and how you can start.
What is diversification?
Diversification is a strategy that involves incorporating different assets into your investment portfolio. There are several ways that you can diversify, but the two main methods are:
1. Diversifying within an asset class, which involves making several investments within the same type of asset (for example, buying multiple cryptos).
2. Diversifying across asset classes, which means investing in another type of asset, like real estate or stocks, in addition to crypto.
The objective of diversification is to minimize losses and potential risk by ensuring that your portfolio’s performance doesn’t rely on only one investment. It also reduces the risk that one event will impact your entire portfolio negatively, as each asset you hold will react to market events differently – the goal is for your investments to be uncorrelated.
Why is diversification important?
Diversifying your crypto portfolio can help you reduce risk.
Firstly, and foremostly, diversifying your crypto portfolio will help you to minimize the risk that one investment’s performance will affect your entire portfolio.
Investors are faced with two main types of risk when purchasing assets. The first is market risk, also known as systematic risk; a few common examples are inflation, interest rates, exchange rates and war, a lot of which we’re currently experiencing. Market risk is a broad type of risk that affects almost every company and cannot be fully mitigated through diversification as it’s typically caused by outside forces that impact a wide array of markets.
The second type of risk is diversifiable, or unsystematic risk. Common examples of this risk type are business risk (any factor which could threaten a business’ ability to generate target profits) and financial risk (the risk that an organization could incur financial losses, or be unable to fulfill its financial obligations). These risks will apply to specific companies, economies, industries, countries – or indeed types of cryptocurrencies.
By spreading your investments across more than one asset or asset type, you can reduce the impact that any of these risks will have on your portfolio.
The second reason why diversification is so important is it can help you to balance your personal risk level. This is particularly important for investors who are planning for retirement, or those that are relying on their portfolio to cover expenses in the short-term.
By investing in riskier coins, in addition to more stable ones that have proven to be successful over a longer period, you can balance out the level of risk you’re taking with your investments in order to achieve your financial goals.
Here are a few ways that you can start diversifying your crypto portfolio today.
Diversify by use case
The most common diversification technique within crypto is to invest in coins that have different use cases, or serve different purposes. A lot of investors believe that every cryptocurrency is just designed to be used as a means of exchange, however, every coin was created to address a different problem.
Similarly to use cases, each cryptocurrency is geared towards serving a certain industry. Some tokens are used for gaming, while others such as XRP are hoping to revolutionise traditional finance. Investing in tokens linked to different industries can help you minimize the negative impact of industry-specific events or anti-crypto policies on your portfolio.
Diversify by location
Diversifying by location reduces the risk that one country’s market or regulations will drastically impact your portfolio balance.
You can also invest in blockchain projects based on where they’re from. This strategy is a good way to mitigate the risk of constantly changing regulatory restrictions. For example, make sure that you’re not solely invested in projects from the United States, such as XRP. Investing in fully decentralized cryptocurrencies such as Bitcoin helps reduce the risk that regulations in a specific country will affect the price of any given token.
It’s worth noting that diversification isn’t a one-time task. When market conditions change, your level of diversification may also change, causing one asset to account for a larger or smaller proportion of your portfolio. The same may happen if one asset you hold does particularly well compared to the others. The best approach is to check and rebalance your portfolio periodically to ensure that it’s still in line with your risk tolerance and financial goals.
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