In case you missed: Part 1 FOMO and FUD
Read time: 14 mins
Diversification is simply a technique that reduces risk by allocating investments across various financial instruments, industries, regions, etc. It aims to maximize returns by investing in different areas that would each react differently to the same event.
And that same event part is important and often overlooked in diversification. Keep this in the back of your mind for a bit - we will look at it shortly.
It is May 5th 2013, the crypto world is oh so new, and let's say you have $1,000USD to invest. You are convinced that Namecoin (NMC), which has the 3rd largest market cap, is way of the future so you decide to only buy NMC at $1.05 giving you roughly 952NMC. Great, you say to yourself, if NMC goes up to $113USD (which was Bitcoin's price back then) then you will have just over $107,000USD for a rate of return of 10,661%!
How could this fail? It is going to surpass Bitcoin and Litcoin for top stop in less than a year - just as soon as everyone else realises NMC is the wave of the future. Surely, you will be rolling in lambos in no time!
Let's fast forward 4 years to May 7th, 2017.
While it didn't quit play out as you hoped, Namecoin is now at 40th spot based on market cap but the price up to $2.27USD for a profit of $1,161USD. Not a bad little rate of return 116% over 4 years or 21% annualized...
Let's fast forward again to today. Isn't hindsight and time travelling fun :-)
Buried deep on page two, now sits our beloved NMC ranked at 168 by market cap with a current price of $1.13USD. Not quit the $113USD price we had hoped for. It is only an 8% rate of return or 2% annualized... Now it is a profit and you probably aren't too much worse off than had you put your $1000USD in a bond with a 2% interest but not exactly lambo money.
So what would have happened if we diversified our initial $1,000USD across all ten of the cryptocurrencies back then. For simplicity, we aren't going to do anything with them, just buy on May 5th, 2013 and hold until today.
Our first scenario, we will evenly split our investment across the ten different cryptocurrencies, so that we invest 10% in BTC, 10% in LTC, 10% in our beloved NMC, and you get the idea.
| 05/05/2013 | 17/10/2017 | ||||||||
|---|---|---|---|---|---|---|---|---|---|
| Coin | Market Cap | Weight | Price | Units | Cost | Price | Value | Profit | |
| BTC | 1,260,000,000.00 | 10.00% | 113.46 | 0.881367883 | 100 | 5,732.29 | 5,052.26 | 4952% | |
| LTC | 61,100,000.00 | 10.00% | 3.53 | 28.3286119 | 100 | 61.29 | 1,736.26 | 1636% | |
| NMC | 5,710,000.00 | 10.00% | 1.05 | 95.23809524 | 100 | 1.13 | 107.62 | 8% | |
| PPC | 5,600,000.00 | 10.00% | 0.30 | 336.3696299 | 100 | 1.23 | 413.73 | 314% | |
| FTC | 2,530,000.00 | 10.00% | 0.40 | 249.596901 | 100 | 0.039229 | 9.79 | -90% | |
| FRC | 2,110,000.00 | 10.00% | 0.11 | 933.2711153 | 100 | 0.005076 | 4.74 | -95% | |
| TRC | 1,350,000.00 | 10.00% | 0.56 | 177.7392281 | 100 | 0.226363 | 40.23 | -60% | |
| DVC | 1,210,000.00 | 10.00% | 0.00 | 363636.3636 | 100 | 0.000023 | 8.36 | -92% | |
| NVC | 971,890.00 | 10.00% | 3.53 | 28.3286119 | 100 | 3.11 | 88.10 | -12% | |
| MNC | 170,590.00 | 10.00% | 0.17 | 599.1791246 | 100 | 0 | 0 | -100% | |
| 1,340,752,480.00 | 7,461.10 | 646% | 65% |
Today that portfolio would be worth $7,461USD. A 646% increase (or about 65% per annum). Still not exactly lambo money but definitely a lot better than if we put everything on NMC.
For our second scenario, we will weight our investment across the ten different cryptocurrencies based on market cap.
| 05/05/2013 | 17/10/2017 | ||||||||
|---|---|---|---|---|---|---|---|---|---|
| Coin | Market Cap | Weight | Price | Units | Cost | Price | Value | Profit | |
| BTC | 1,260,000,000.00 | 93.98% | 113.46 | 8.282837803 | 939.7707771 | 5732.29 | 47,479.63 | 4952% | |
| LTC | 61,100,000.00 | 4.56% | 3.53 | 12.9097519 | 45.57142419 | 61.29 | 791.24 | 1636% | |
| NMC | 5,710,000.00 | 0.43% | 1.05 | 4.056002371 | 4.25880249 | 1.13 | 4.58 | 8% | |
| PPC | 5,600,000.00 | 0.42% | 0.30 | 14.04934882 | 4.176759009 | 1.23 | 17.28 | 314% | |
| FTC | 2,530,000.00 | 0.19% | 0.40 | 4.709893653 | 1.887000052 | 0.039229 | 0.18 | -90% | |
| FRC | 2,110,000.00 | 0.16% | 0.11 | 14.68729003 | 1.573743127 | 0.005076 | 0.07 | -95% | |
| TRC | 1,350,000.00 | 0.10% | 0.56 | 1.78965142 | 1.006897261 | 0.226363 | 0.41 | -60% | |
| DVC | 1,210,000.00 | 0.09% | 0.00 | 3281.739222 | 0.902478286 | 0.000023 | 0.08 | -92% | |
| NVC | 971,890.00 | 0.07% | 3.53 | 0.205349571 | 0.724883985 | 3.11 | 0.64 | -12% | |
| MNC | 170,590.00 | 0.01% | 0.17 | 0.762362691 | 0.127234521 | 0 | - | -100% | |
| 1,340,752,480.00 | 48,294.11 | 4729% | 164% |
Now, we are talking - $48,294USD! We can at least afford a timeshare in a lambo.
Back in May, 2013, we didn't know what would happen. We didn't know Bitcoin would hold its dominance so strong against all of the other altcoins. We had a 1 in 10 shot at hitting the highest profit (if we put 100% on BTC), 2 out of 5 chance of hitting a coin that had a positive rate of return and 3 of 10 odds of picking a coin that had any serious level of return. Even with those odds, you are more likely to pick the wrong horse. In May, 2013 there were only 10 coins listed on coinmarketcap.com - now there are 1175 - the odds are even less in your favour and getting less and less favourable each day.
By diversifying, we hedge our bets. We are reducing our risk - in the case that our coin we picked won't be the chosen one and won't rocket to the moon. Even with the scatter gun 10% approach on each coin, our performance was better than 8 of the 10 coins. The odds shifted in our favour. I don't know about you but I would rather a 9 in 10 chance of making 4000%+ returns than a 1 in 10 chance of picking the winner.
You are not going to make the best returns possible - sorry to burst your bubble - but you are going to have a much better chance at making decent returns.
Which leads me to:
Rule #3 - Don't put all your eggs in one basket
Putting your eggs in different baskets allows you to get greater exposure to the winners while at the same time reducing your exposure to the losers. That is simply put as reducing our risk.
Above is a great start to diversification but it isn't true diversification. If you overlay the price movements for each of the 10 coins from May 5th, 2013, they are highly correlated - that is - they all tend to rise and fall at the same time. Remember, that bit above regarding acting differently to the same event, this is what makes true diversification.
Let's look at some recent events and see how diversification can have an impact. First here, is the crypto-king Bitcoin over the past 3 months. Early September saw the price sharply decline as news came out that China was banning ICOs and the closing down exchanges and then October where there has been a strong bull rally as people are keen to get their dividends in the form of Bitcoin Gold.
BTCUSD
Compare this to Litecoin's BTC comparison:
LTCBTC
Almost an inverse to BTC - these coins can be said to have high correlation - each does not react differently to the same event.
But now, let's take a look at Ripple (XRP) and Ethereum (ETH) for the same time period.
XRPBTC
ETHBTC
Besides the past couple of days, both of these have not moved the same as LTC - they acted differently to the same events. In other words, low (or at least lower than LTC) correlation. Ripple, Ethereum and Bitcoin have very different use cases and value propositions - whereas Bitcoin and Litecoin share the same – so it isn’t surprising they have a lower correlation.
By diversifying, in low correlation coins, you are lower your risk is a very NEWS-DRIVEN market. This way the same news or events (for better or worse) won't take your whole portfolio with it.
Over the long-term this will have a beneficial impact on your portfolio. You won't have to check your portfolio or the charts every 5 minutes. The FOMO and FUD (see Part 1) is going to have less of an impact cause you will safe in the knowledge whatever is on the radar for crypto you will be able to weather because you are well and truly diversified.
To summarise:
Rule #4 - Look for coins that have price low correlation
While this post, really only discusses diversification within your crypto portfolio, your overall portfolio should also diversify among different asset classes, meaning allocating a certain percentage to cash, bonds/fixed income, commodities, real estate, stocks/equities and so on.
So, I do have to add:
Rule #5 - Crypto isn't the only investment opportunity
Absolutely!
"Wide diversification is only required when investors do not understand what they are doing." -Warren Buffett
If you diversify too much you might not lose much, but you won't gain much either. There have been a number of studies into stocks which suggest there is a diminishing law of returns for over diversifying. Modern Portfolio Theory and Investment Analysis, found a portfolio with 20 stocks reduced the risk by about 20%. While the first 20 stocks reduced the portfolio's risk by 29.2% each additional stock up to 1000 only reduced the portfolios risk about 0.8%.
I haven't seen anyone repeat their study with cryptocurrencies but I would suspect it to be roughly similar. Personally, I usually hold between 15 to 20 coins at any given time.
TL;DR
Diversification can help reduce risk and volatility of your portfolio. Remember though, that no matter how diversified your portfolio is, risk can never be eliminated completely.
While, you can reduce risk associated with individual coins, general market risks and volatility affects nearly every cryptocurrency whether it is Bitcoin or Bubble Coin, so it is also important to diversify among different asset classes.
I would love to hear in the comments below what tools or strategies you use to diversify or how you have benefited from diversification.
Thanks, and until next time.
