Diversification is one of the most well known terms in the investing world. Whether your an active investor or a average joe with nothing but a 401(k); you have heard this term and know what it means.
Definition of Diversification (in my words)
Diversification is to mitigate portfolio risk through the use of several different investment assets/classes.
Here is where the issue lies
- Correlated Investments
There is a limit on the mitigation of risk when it comes to correlated investments and when you hit the saturation point, additionally diversification essentially has no impact.
Basically it goes like this, you need to 15 investments to be truly diversified. However, if you do 15 investments within a correlated group of assets you max out on a 20% diversification of risk.
On the flips side, if you invest in 15 assets that have very low correlation you can diversify your risk out by up to 80%!
Note: I have seen research on this before, but was reminded of it when listening to Ray Dalio, founder of Bridgewater Associates and basically the Steve Jobs of Hedge Funds.
Even though he is not high on bitcoin, I believe many people will like his viewpoints as his entire business is run using a meritocracy system, which is a very pro decentralization social environment and likely one of the reasons his fund is near the top for three decades now.
How does this impact my Crypto Investments?
Well, it's pretty simple. Just like investing in only stocks limits your diversification, so does only investing in crypto.
I purchase 15 different stocks througout the eleven different sectors that make up the S&P 500.
How diversified is my risk exposure? The answer is - 20% at the absolute maximum.
Even though I have invested in several different industries, I am still 100% in stocks and impacted mostly by the overall movement of the market as a whole.
The same holds true for crypto. I hold 10 different crytpo currencies. Despite some of them having different technologies, such as BTC vs ETH, in the end they are both within the crypto market.
They may not trade 100% in unison, but in the end they will be within a given standard deviation of each other.
By me adding 5 more different coins I am going to get very little increased diversification of risk since they are correlated investments.
Obviously once you get out of a single investment space you will see the correlation drop, but there will almost always be some correlation despite how small. There is plenty of research on this out on the web, but for the purpose of this post I will just give a quick example:
- Rental Real Estate
- Crypto Currency
- Foreign Markets Index Fund
Based on this mix my investment risk is diversified pretty well.
If the crypto currency market crashes, it really won't impact my real estate much. Just as if the markets overseas have a down year it will only have marginal impact on real estate in the U.S. and vice versa.
In the end, none of these asset classes have a major correlation with one another.
However, as I stated earlier. I could buy 15 different cryptos and in the end my majority risk is tied to the crypto market on a whole.
If you are like me and don't want to sell any BTC - get diversified buy investing in stocks or currencies using bitcoin instead of fiat currency! I do this with 1broker.com thus mitigating my BTC risk while still holding on to it.