How to DIVERSIFY your crypto portfolio - Part 1 - Intro

in #cryptocurrency6 years ago (edited)

Intro to the Intro

Diversification is not easy. It's not a case of "I have $10 here, $20 here and $30 here - so I have $60". It's a careful balancing act based on future values and potential returns on investments. It's about hedging bets, spreading risk and executing multiple strategies on a wide variety of crypto assets. Simultaneously.

Diversification - Introduction

To get the ball rolling, let's work through a small example thought experiment:

When buying a new crypto you want to look at a few things: How long will you hold it? Do you need a stop loss level on it? What will you buy it with (fiat/BTC/ETH/NEO etc)?
There are four major decisions to make: Risk of each coin, Reward from each investment, Amount to invest in each and Number of investments to make.

After doing all of the necessary research into the coins you are interested in, you will be left with two factors: risk and reward. Or at least your assessment of potential risk and reward. You use those two to decide what risk and what reward factors you are happy with. From that you get which of the coins you researched you are going to buy. Once that has been decided, you need to decide how many different coins to buy and how much to put into each.

The process of selecting coins on risk and reward is simple and probably already widely understood. In short - multiply chance of success by estimated ROI and voila! You have a relative strength factor with which to compare your choices. I will not deal with that any further here. Let's look instead at how you spread your investment around:

How much and how many?

Let's say that you have $300 to invest. You put it all into three low risk, low return investments. They each have a projected ROI of 20% and a success probability of 90%. The maths for that is easy.

Now you have the same $300, but you decide to put $30 apiece into 10 different investments. Medium risk, medium returns. Projected ROI is 100% for all of them and success probability is 65%. Again, easy calculation.

Now you take the $300 and put it into 30 different high risk/high return investments. Projected possible ROI is 1000% and chances of success are all 10% each. Easy to calculate.

But what if you put $100 into one low risk, low return investment; $30 apiece into three medium risk, medium return investments; and $10 into eleven high risk, high return investments? Well you could calculate it as an overall system; add up the probabilities of success and projected ROIs of each, get a figure, and compare to your other potential investment strategies. You could reduce it to a number, a quantitative assessment. You could compare that to other numbers and decide which is the best strategy.

But that's not the whole story. Because now you have cast a nice wide net and diversified your portfolio. You've spread various amounts around through various assets. You have now vastly increased your chances of picking up erratic market behaviour in at least one investment, you've moved away from the bell curve; and at the same time you've still invested most of your funds relatively securely.

Normally you can assume a normal distribution of probability in your calculations, it's what you subconsciously base your very risk and reward figures on when you estimate them. Probability states that you will pick assets that behave like the norm. Why wouldn't yours behave like the norm? There is only a very small chance, when investing in a single asset, that it will behave highly abnormally.

standard-normal-distribution.jpg
From http://www.statisticshowto.com/bell-curve/

But by splitting your investment into many smaller investments and putting different amounts into them, you have over-populated this bell curve to the point where you must have a few outliers, those in the area beyond two standard deviations or so. If you're in luck they fall on the right side of the curve and you'll make a lot of money. If you aren't so lucky then they fall on the other side and you'll lose. The more coins you invest in, the greater the chance of having coins that will perform far from the normal market behaviour. You want this erractic behaviour because you may be able to exploit it for large profits.

Don't make the mistake of trying to invest in all of the coins. While technically not really the same, that could be thought of as betting on all the numbers on the roulette table simultaneously: statistically you'll still lose at the end of the day.

The same could actually be said for many small high risk investments, but in practice that is a very difficult and possibly costly portfolio to manage. Would you want to manage a portfolio of 50 different coins with $10 invested in each? No, you wouldn't, and quite frankly, you must be crazy to invest like that. But investing just a third of your money that way can be done without too much trouble

What's my point? Well the point is that probability breaks down a bit once you start investing in enough different things. This makes it impossible to calculate the chances of success and to evaluate a portfolio on numbers alone.

Starting to diversify:

You invest about a third of your money into some low risk, stable coins with relatively low growth. (Exactly how many different coins is up to you, it will depend on how many you like and how much you have available to invest). In the crypto world these would typically be your top 10, or perhaps top 25 market cap coins.

Then you invest the next third into smaller, but stable coins. These are coins that should do well, but may disappoint. They don't have the market cap of the first coins. Think along the lines of ETHOS or TenX or Power Ledger. These coins will probably make higher returns than the first batch, but one or two may fail entirely.

Now your portfolio has quite a few coins that should make you money, and most of your investment is relatively safe. But I would argue that it is too safe. Risk profile is an individual choice, but if you want high reward, then you need high risk.

This is where the last third comes in. All those little $10 investments spread around. A few of them are almost certain to rocket in price, especially if you choose carefully. The nice thing about these investments is twofold:

  • If a specific coin fails you only lose $10.
  • Small coins "Moon" easier. They are far more likely to have an ROI of 10x or more than a large market cap coin does.

I love some of the big coins, but I don't expect my NEO to go 10x this year (hell, right now I'd just settle for it to stop losing value!)

Note that I'm not saying "invest $10 in each small coin you choose", that's just from the $300 example above. But you get the picture, the point is that the amount is small.

Conclusion (of part 1)

Diversify; cast that net wide. Then when you catch a coin that shoots up in price: analyse it quickly - do you want to keep it? Normally that would be a "no", in which case sell it and take the profits, some of which you can reinvest.

A diverse portfolio let's you be a part of the action. You can't just sit on a pile of e.g. LTC and nothing else, then moan every time ONT or ADA or Nano shoots upwards and your coin doesn't.

Diversification also protects you from losing a lot if one or two of you coins crash. If you only hold LTC and LTC happens to crash, then you're ruined. But if you hold 1/3 LTC and LTC crashes, then you still have 2/3 of your portfolio. Many people only hold a few very big coins and nothing else. If those coins crash... (they shouldn't but they can - ask the Bitconnect investors!)

This was just a little intro to diversification, just to get your mind wrapped around the idea if you haven't thought of it before. I will speak more on this topic, much more. I have a ridiculously diverse portfolio (a minor nightmare to track), so believe me when I say I know what I'm talking about. I'll be happy to answer any related questions.

Until next time

Yours in crypto,
Bit Brain

DISCLAIMER:

I am not a financial advisor nor am I a professional trader/investor. This is not financial advice, investment advice or trading advice. Unless otherwise stated, all my posts are my opinion and nothing more. Crypto is highly volatile and you can easily lose everything in crypto. You invest at your own risk! Information I post may be erroneous or construed as being misleading. I will not be held responsible for anything which is incorrect, missing, out-of-date or fabricated. Any information you use is done so at your own risk. Always Do Your Own Research (DYOR) and realise that you and you alone are responsible for your crypto portfolio and whatever happens to it.

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This is some good advice, a real public service announcement. @bitbrain

Thanks! I'll keep them coming.

Nice article!
Upvoted and resteemed

Glad you liked it.

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