Just Diversify? With Crypto Portfolios, It's Not So Simple

Tanzeel Akhtar is an independent British journalist whose work has been published in the Wall Street Journal, CNBC, FT Alphaville, Investing.com, Forbes, Euromoney and Citywire.

With over 1,560 cryptocurrencies for investors to choose from, the abundance can seem overwhelming.

But it also raises an interesting question: How important is it to have exposure to a range of cryptocurrencies? Is it worth diversifying your holdings in order to mitigate risk? The work of Harry Markowitz might lead you to think so.

The Nobel Prize-winning economist, author of the classic 1952 article "Portfolio Selection," devised modern portfolio theory (MPT), which stresses that diversifying assets is crucial. If you diversify enough, you will make risk go away and get the mean. Time and time again, Markowitz's research has shown that investors can assemble the perfect portfolio.

Indeed, recently published research by the Bocconi Students Investment Club at Bocconi University in Milan, Italy, showed that applying the MPT framework to crypto beat all other portfolios, at the cost of a greater volatility.

The investment club wrote:

"Our findings, consistently with MPT, are that portfolio variance can be significantly lowered by exploiting low covariances between coins."

In this way, it's a validation of the idea that 50 to 60 percent of a crypto portfolio should be core holdings of the two largest coins by market capitalization, bitcoin and ether. Alternatives, the thinking goes, should be added only after.

Jeffrey Van de Leemput, a co-founder of Cryptocampus, a crypto mentoring group, says diversifying your portfolio is very important. Not only will this mitigate risk but it can also substantially increase the reward factor of a portfolio.

"Personally, I like having 80 percent large caps and 20 percent small caps mixed in for performance," says Leemput.

All go down together

But this risk mitigation strategy may be hard to pull off in crypto. When we saw the price of bitcoin plummet earlier this year, it dragged all the other cryptos' prices down too.

Hence, some disagree with Markowitz's theory, or at least its applicability to the brave new world of cryptocurrency.

Dejun Qian, founder of the FUSION Foundation, a public blockchain project, says diversification could help to increase the possibility of finding a good bet. He warns that in this market, 90 percent of the projects will die in the future. Diversifying will help us to capture that 10 percent.

The fun part is hunting for those golden nuggets – the initial coin offering (ICO) tokens and small caps that you believe will have the potential to succeed in the long run. But in most cases, diversification doesn't help with limiting risks because cryptocurrencies have repeatedly entered periods where they move in tandem, Qian said.

And it bears repeating that in this market the risk is high and crypto investing is not suitable for every investor. Do your own research.

That includes at least entertaining the arguments of so-called maximalists, who claim that there can only be one winner in cryptocurrencies (whichever one they've invested in, naturally), because money relies on network effect.

Maximalists can be rude and clannish, especially on Twitter, but that doesn't mean they're wrong. And if they're right, diversification is just "spraying and praying."

Going mainstream

Then again, stocks and bonds aren't riskless either, and even some Wall Street analysts say crypto itself could serve as a diversification play for mainstream investors.

JP Morgan strategist John Normand examined the potential role of cryptocurrencies in diversifying a global portfolio in a 71-page research report on cryptocurrencies published in February.

He wrote:

"Given both their high returns over the past several years and their low correlation with the major asset classes, offsetting some of the cost of high volatility. If past returns, volatilities and correlations persist, CCs could potentially have a role in diversifying one's global bond and equity portfolio."

Qian observes that we have seen the market cap of cryptocurrencies soar from no more than $1 billion to $700 billion early this year (though it was down to $329 billion at the beginning of June). No one can deny this market is becoming more and more important. But it remains very small compared to the fiat currency market.

"Along with this exponential growth, having some cryptocurrencies in someone's investment portfolio not only can help him catch the return from this booming but also can help him to understand more about this new world," says Qian.

Summing up, Markowitz's MPT is for risk-averse investors.

It is a well-known investment strategy which guides investors to combine a portfolio of assets with returns that are not always positively correlated in order to lower portfolio risk without sacrificing return. But be warned that crypto is not yet a mature asset class and hugely volatile therefore correlation and patterns are difficult to predict.

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