What is diversifying investment?
Diversifying investment is a risk management strategy that involves investing in a portfolio of securities to reduce the risk the failure of specific assets. This way, investors can more comfortably withstand a decline in the value of their properties.
Diversification is a pillar of modern portfolio theory, and it has a wide range of applications in financial decision-making. Individuals and businesses both diversify their portfolios. The former diversify their investments by investing in individual activities, while the latter diversify their investments by investing in portfolios rather than individual properties.
Investors are believed to be risk averse in portfolio theory, which means they prefer lower risk to higher risk for a given return and will tolerate a higher risk only if rewarded with a higher return. This results in indifference curves, which are lines on which risk and return combinations are provided to investors, and investors are indifferent about where to invest as long as they are on this line.
Specifically, as risk rises, so does return, allowing investors to be rewarded for the elevated risk they are taking. The estimated return on a single asset investment is the sum of the investment's returns conditional on the likelihood of each return occurring.
For example, if there is a 60% risk that an investment will earn a 5% return and a 40% chance that it will earn a 15% return, the estimated return on this investment is 9%, which is the weighted average of the likelihood of each event occurring. Furthermore, the estimated return on an investment portfolio, i.e., a set of investments, is the weighted average of the returns of the portfolio's individual holdings.
On the other hand, variance tests the variability of returns and is used as a risk indicator for individual assets. The variance of a single asset is the square root of the difference between the realized and projected return.
The correlation coefficient of securities is at the heart of diversification. Since a portfolio's variance is made up of two components, the variance of individual securities and the correlation coefficient, when two assets are negatively correlated, i.e., when the second component is negative, the portfolio variance is greater than the other's portfolio variance.
To put it another way, investing in securities with negative correlation reduces the portfolio's overall risk. Since the second term of the portfolio variance is zero if the correlation is zero, the variance of the Diversifying Investment portfolio is essentially to the sum of the individual variances of each stock in the portfolio.
The only premise is that the risk-return combination of the portfolio would be better than the risk-return combinations of all individual stocks as long as the individual stocks are not perfectly correlated. As the degree of association decreases, diversification becomes more advantageous.
And what about diversifying a crypto portfolio?
The preceding also applies to portfolios containing assets from more than two different cryptocurrencies. Despite the fact that calculating the correlation of more than two cryptos becomes extremely difficult, the concept of diversification extends to complex portfolios, ensuring that no crypto is perfectly positively correlated.
Furthermore, as the number of crypto assets in a portfolio grows, the value gained from diversification by adding another asset to the portfolio diminishes. In other words, the advantage of minimizing risk by increasing the number of crypto in a portfolio is outweighed by the additional costs (transaction and tracking costs) that come with increasing the number of cryptocurrencies.
Diversification, on the other hand, has its limits. The two forms of risk that are embedded in asset prices set these limits. The first category of risk is known as unique or unsystematic risk, and it refers to the impact of unpredictable incidents on crypto space. These activities are one-of-a-kind and can be varied.
The technology advances every minute and a crypto project may be relevant now but obsolete tomorrow. The investors should be up to date all the time and truly informed about the capabilities of the project the invest their money in. One way to minimize the failure risk is to create portfolios of crypto that share very few common elements.
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