Which cryptocurrencies to buy?
A heat map of cryptocurrencies from Yahoo Finance. Block sizes indicate market capitalisation, while the colours show movement up (green) or down (red).
Tracker funds and passive investing
My initial idea was to take a list of cryptocurrencies and invest in them with passive investing just like a tracker fund would.
This means taking a list of the top cryptocurrencies, and buying them in the same proportions as they are relative to the overall cryptocurrency market. In this way, I can buy and hold, or I can re-balance my list at whichever regular time intervals I choose.
Re-balancing here means taking another look at the top cryptocurrencies, and selling off the ones which are no longer on top in favour of buying those which are currently at the top. The process is thus pretty much repeated, only you don't start from scratch, you start with what you already have and adjust the proportions according to new market capitalisations.
The reason for doing this is diversification. We want to allocate our capital in such a way that we minimise exposure to one particular asset.
How many cryptocurrencies to select?
A chart from the Wiki page on diversification, relating diversification to risk reduction.
As can be seen from the Wiki page on diversification, the benefits of diversification tapers off with each additional asset. This means there is a sweet spot value somewhere between four and around thirty assets, which frankly I'm going to thumb suck.
Given that cryptocurrencies are new, volatile, and investing in them at this stage amounts to speculation, I don't foresee how the majority of them are going to last. The ones that are going to last will have to be useful somehow, in other words have inherent value, and address the shortcomings of some of the more infamous ones.
A list of cryptocurrencies by market capitalisation from Yahoo Finance.
My thumb suck value is five. I'll split the cryptocurrency component of my portfolio equally between four cryptocurrencies. You can at this point just take the top five, divide your crypto component with five, invest your fifths, and let the chips fall where they may. The benefits of this approach are it's simple, the big ones already have fairly easy access to wallets and exchanges, and it will be the easiest. I'm going to follow a slightly different approach. Why?
Bitcoin risk is becoming centralised
What do I mean? There are plenty of cryptocurrencies that are derivative of Bitcoin one way or another. This means that if Bitcoin crashes, all of those are also likely to crash along with it.
As the most famous cryptocurrency out there, it is worth looking at some of Bitcoin's shortcomings, and seeing how certain other cryptocurrencies either address those, or at least are not linked to Bitcoin's value in any way that the risk may spread if Bitcoin crashes.
I'm pretty much set on purchasing more Bitcoin and Ethereum, as these are based on entirely different proof-of-work schemes and they address different problems. Monero is one that I would also like to invest in, because I value privacy. Luno, my country's biggest exchange, supports Bitcoin and Ethereum, so I've transferred some funds to them in the meanwhile. Monero is slightly more difficult to get into.
I'll expand on my reasons for settling on these in subsequent posts. Right now, I just wanted to introduce the idea of index tracking and consider how it may be used as an investment strategy in cryptocurrency. Remember to invest only a small proportion of your portfolio in crypto, as it's still volatile and very risky.