Did you know that there are currently over 1,560 cryptocurrencies in the world? For investors, that’s a nightmare to choose from and for newcomers to the cryptocurrency industry, it can be overwhelming. Even the most seasoned foreign exchange traders will be put off by the staggering number of choices you have, but it does raise a few questions.
For instance, how many cryptocurrencies do you need to be exposed to in order to have a diverse portfolio? And to follow that, is it even worth investing in several different cryptocurrencies to mitigate risk, much like any other investment? Or is the reverse true and it’s only worth your time to invest in the most popular cryptocurrencies such as BitCoin?
To help answer these questions, we need to turn to Harry Markowitz, the Nobel Prize-winning economist. Markowitz states that if you diversify your assets enough, you eventually mitigate all risk and get the mean. Markowitz’s research has shown that investors can put together the perfect portfolio, but does this work for cryptocurrency?
It appears so.
A 2017 study by the Bocconi Students Investment Club showed that applying the MPT (modern portfolio theory) framework by Markowitz beat other portfolios but at the cost of a greater volatility. They wrote, “Our findings, consistently with MPT, are that portfolio variance can be significantly lowered by exploiting low covariances between coins.”.
The idea is that around a half of your cryptocurrency portfolio should be core holdings, such as BitCoin and Ethereum. Alternatives should only be added after you have a strong presence with your core holdings. The co-founder of Cryptocampus, Jeffrey Van de Leemput, mentioned that a diverse portfolio is important because it not only mitigates risk but can also be used to substantially increase the reward factor of a portfolio. He said, “Personally, I like having 80 percent large caps and 20 percent small caps mixed in for performance.”
Sadly, a risk mitigation strategy might be difficult to pull off with cryptocurrencies. When the price of BitCoin plummeted this year, it had a rippling effect that also brought down the price of other cryptocurrencies. This is why many people disagree with Markowitz’s theory when applied to the world of cryptocurrency.
Dejun Qian, the founder of the public blockchain project FUSION Foundation, says that diversification can help increase the possibility of finding a good cryptocurrency bet. He says that around 90% of cryptocurrency projects will die in the future, so diversifying will help to land on the other 10% where investors can find stability.
Unfortunately, hunting for these golden nuggets can be time-consuming and risky. Qian said that diversification is just “spraying and praying”, which harkens to its high-risk high-reward nature.
Other analysts claim that cryptocurrency itself is a diversification play for larger investors. No one can deny that the cryptocurrency industry is growing, but combining a portfolio of assets such as cryptocurrency may be a smarter move than focusing on cryptocurrency itself due to its volatile nature and patterns that are hard to predict.