The Benefits of Diversifying Your Crypto Portfolio
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Deciding to go all-in is a brave but very risky move not just when playing poker.
When trading crypto, even if you’re into Bitcoin or a firm supporter of smart contracts, all crypto experts preach that your portfolio should cover a wide variety of assets apart from large-cap coins.
This simple advice is based on the idea that you should always have a safety net in case all large-cap crypto coins suddenly crash. If that should happen, you won’t get liquidated from your entire portfolio.
Read below to understand more about the reasons why diversifying your crypto portfolio is a wise move.
What Is Diversification in Crypto Trading
Diversifying your crypto portfolio is a basic risk management technique whose core theory suggests you shouldn’t risk your entire investment amount on a single type of cryptocurrency. Instead, you should allocate funds to a mix of digital assets to create a balanced portfolio that can withstand market fluctuations and capitalize on different market trends.
With a well-diversified portfolio, there’s very little chance that all your crypto investments will plummet simultaneously.
So, how does a well-diversified portfolio look like? Many traders follow the 80/20 rule, where 80% is allocated to the largest and most established cryptocurrencies, like Bitcoin and Ethereum. The rest of the 20% is divided among any mid and low-cap cryptos that you consider favorable.
However, this rule doesn’t necessarily apply to every trader.
You might as well dedicate 50% to Ethereum and Bitcoin and spread the other half to 5 or 6 different altcoins and it’s still a good diversifying strategy.
What Are the Benefits of Diversifying Your Portfolio
- Mitigate risks
The main advantage of diversification is risk reduction. Cryptocurrency markets are known for their volatility, with prices often experiencing sharp fluctuations within short periods. By diversifying your portfolio, you can minimize the impact of adverse price movements in any single asset on your overall investment performance.
The negative impact of a decline in one asset may be offset by gains in others, helping to preserve your capital.
- Get exposed to different use cases
Each cryptocurrency operates within its unique ecosystem and is subject to various market dynamics and factors. With a diversified portfolio, you gain exposure to different market trends and sectors within the crypto space.
For instance, while Bitcoin may serve as a store of value and a hedge against inflation, Ethereum is the backbone for DeFi protocols and smart contract technologies, while Ripple facilitates money transfers in financial institutions.
When you invest in cryptos with diverse use cases, you're not just buying currencies; you're investing in different technological innovations and applications.
Practical example
Suppose you allocate a portion of your portfolio to Ethereum for its smart contract capabilities and its role in powering decentralized applications (DApps). Additionally, you invest in Polkadot (DOT) for its focus on interoperability between different blockchains. If the DeFi sector experiences significant growth, your investments in Ethereum and Polkadot may benefit from increased adoption and usage within the ecosystem.
- Enhance potential returns
While diversification primarily aims to mitigate risk, it can also potentially enhance returns by capitalizing on opportunities across different cryptocurrencies and market sectors. When you spread your investments, you increase the likelihood of benefiting from assets that outperform the broader market.
This reduces the impact of market volatility on your entire portfolio, allowing some investments to hold steady or even rise in value when others might be underperforming.
Practical example
Imagine you diversify your portfolio by allocating funds to a mix of established cryptocurrencies like Bitcoin and Ethereum, and emerging altcoins with high growth potential. If one smaller altcoin experiences a substantial price surge due to positive developments or market hype, your overall portfolio returns may be amplified by the performance of that particular asset.
- Hedge volatility
By spreading your investments across different coins and tokens, you will be less exposed to the consequences of a negative news event or market downturn. This will enable you to weather the storm and continue to grow your portfolio, minimizing your investments’ overall volatility.
- Adapt to market changes
A diversified portfolio allows you to be more adaptable to market changes. As the crypto market evolves, so can your investments, enabling you to take advantage of new opportunities and technologies as they arise.
Diversification is not just about immediate gains; it's a long-term investment strategy. It allows you to weather market fluctuations and positions you for sustained growth over time.
Key Takeaways
If you spread your investments across a mix of digital assets with varying risk profiles and growth prospects, you’ll create a more resilient portfolio and capitalize on diverse opportunities within the crypto space.
Apart from selecting the right assets, you also need to know how to manage and distribute your investments across different assets to optimize your portfolio's performance.
Whether you're an advanced trader or a newcomer to the world of cryptocurrency, adopting a diversified approach to portfolio construction can help you achieve your investment objectives in the long run.