Why Diversify Your Cryptocurrency Investment Portfolio
Cryptocurrencies are a young asset class with features of currencies, securities and commodities. Their inherent high volatility and low threshold for entering the cryptocurrency market allow investors to both extract multiple profits from investments and lose fortunes in a matter of days. Should you include bitcoins in your investment portfolio and is there the safest strategy for investing in cryptocurrencies - these are the main questions that investors who are thinking about buying cryptocurrencies will have to answer.
Table of contents:
- Bitcoin and Investment Portfolio
- Bitcoin and the Averaging Strategy
- What Is Portfolio Diversification?
- Five Steps to Form Your First Investment Portfolio with Minimal Risks
Cryptocurrencies are a young asset class with features of currencies, securities and commodities. Their inherent high volatility and low threshold for entering the cryptocurrency market allow investors to both extract multiple profits from investments and lose fortunes in a matter of days. Should you include bitcoins in your investment portfolio and is there the safest strategy for investing in cryptocurrencies - these are the main questions that investors who are thinking about buying cryptocurrencies will have to answer. There are some more important questions a novice investor should find answers to. Why is it necessary to diversify assets in order to properly organize an investment portfolio? Why can't you focus on one tool, even if it shows itself to be quite stable? It would seem that the task of an investor is to extract maximum profit from the invested funds, so why not choose one profitable asset and calm down on this? Read our article about what diversification is, how to make an investment portfolio correctly and what sum would be enough to start with.
The basis for the formation of any investment portfolio begins with the definition of the ultimate goal, the definition of time frames, but the most important, perhaps, is the assessment of the investor's risk tolerance. All investments carry some degree of risk, and there is no guarantee that when you withdraw your investment, you will receive more money than you originally invested in it. Investors form portfolios according to their willingness to take risks. High-risk assets allow you to get more profit, but can cause significant losses. Low-risk assets allow you to reduce the risk of losses, but you should not expect high returns from them. Diversifying funds across asset classes and sectors helps spread these risks.
And for these purposes, bitcoin, with its low correlation with other assets, comes in handy. Bitcoin is another asset, it's not stocks, it's not bonds, it's not gold. The correlation of Bitcoin with traditional assets is low, which means that including it in an investment portfolio increases diversification and helps to hedge risks. At the same time, due to the growth of the cryptocurrency market in the long term, which we have been observing over the past ten years, the presence of bitcoin in the portfolio can significantly increase the overall profitability of the portfolio. According to various estimates, the share of bitcoin as a high-risk asset in the portfolio should not exceed 10%. According to Lee and Tsivinsky of Yale University, bitcoin should be about 6% of every portfolio. Since the number of bitcoins is fixed, this asst is protected from inflation. Based on this, Bitcoin can be considered an excellent long-term investment.
In a popular anecdote about traders, a beginner is perplexed when talking to an old-timer in the financial market: is it difficult to buy assets when they are at the bottom and sell them for multiple profits when they rise in price? In practice, not every professional succeeds in predicting market movements and determining whether an asset has fallen to the bottom or is in the middle of the path. More often, the opposite situation is observed: investors, succumbing to the general mood in the market, buy an asset at its peak and sell it at the most inopportune time, fixing losses rather than profits. A strategy of averaging dollar costs (Dollar Cost Averaging, DCA) can help get rid of unnecessary emotions associated with investing.
This strategy involves buying the same asset in equal portions at regular intervals, regardless of the ups and downs in the market. In this way, the investor manages to mitigate the risks associated with buying an asset at the wrong time (for example, when it was at its peak, and then fell sharply in price). By investing only $100 monthly in cryptocurrencies, in five years, the investor would receive a tenfold return, according to the minimum calculations. At the same time, its risks would be evenly distributed over time. As noted by the Financial Services Regulatory Authority (FINRA), this strategy offers a lower return than a profitable one-time purchase of an asset at the bottom, but is ideal for investors who are not prone to high risk and are ready to invest with an eye to the long term. Bitcoin is convenient because anyone can buy it. No need to enter into contracts with brokers, there are no entry thresholds. You can buy cryptocurrencies for both $20 and $20 million. And modern services, such as Quickex, allow you to purchase bitcoins in minutes. You won't be able to buy Apple shares or invest in government bonds with such ease.
The term “diversification” comes from the adjective diverse, different. Diversification as a financial method reduces the risk of investing by distributing the amount of invested funds between financial instruments from various industries and categories. Ultimately, the method is aimed at maximizing profits due to the fact that each of the areas reacts differently to the same event. By diversifying your investment portfolio, you do not depend on one asset, as you reduce the risk of capital loss in the event that an asset loses a significant part of its value. You invest in various assets, partly in risky ones with higher returns, partly in traditional ones with a lower percentage of returns, but safer ones.
Thus, at the exit, you get a portfolio balanced by the level of risk acceptable to you personally and the profitability that you expect to receive. Traditional assets that will not let your investments burn out in a falling market are treasury bonds; riskier assets are national currencies, precious metals, real estate, ETFs, exchange-traded funds, stocks. For people with high risk tolerance, there are high-risk assets, such as cryptocurrencies, investing in which you can get windfalls in a growing market. How much to invest in each type of asset depends on how quickly you expect to make a profit and, more importantly, what degree of risk is acceptable to you. Simply put, how much are you willing to lose without compromising mental well-being? This question is, perhaps, the most important for investors.
Here are five steps that you need to follow in order for the investment portfolio to fully meet your individual needs, generate income and meet security requirements. Define Your Own Planning Horizon When forming an investment portfolio, an important factor will be determining the so-called planning horizon, in other words, how many years you have in stock before you stop actively investing in the portfolio the funds you earn. If you have up to 10 years left before retirement, then you will have to invest more, but if you have 20-30 years of productive work ahead of you, it will be enough to regularly allocate a small percentage of income to form a portfolio. Be guided by such figures: it is good when by the age of 30 the value of the portfolio is equal to your annual income, by the age of 40 it is triple its size, and by the time you turn 60, the portfolio should grow to seven times the size of annual income. For a novice investor, the best option would be to invest a small percentage of monthly income in a portfolio. The specific amount will depend on the direct amount of income and the availability of mandatory monthly expenses such as loans and tuition fees.
Depending on the current situation, choose an acceptable amount that will be easy for you to part with. At the beginning of the journey, it is not so much the size of the investment that is important, as the regularity of investment. In order for the entry into the investment mode not to be abrupt, start with 5%. Such an amount can be mastered by anyone without prejudice to the budget. There is no need to invest all available funds, they may be needed at any time in emergency situations — for treatment, car repairs, help for loved ones. After six months, if circumstances allow, you can start raising the amount and bring it, for example, to 10% of your monthly income. After the next six months, you can increase the share of investments to 15% of income per month. It is not recommended to invest more than 20% of income in an investment portfolio — a measure is needed in everything. Assess the Degree of Individual Risk Tolerance In investing, it is important to determine how risky you are. It is clear that everybody wants the income to be as high as possible, but those assets that are able to show a sharp increase in price have one unpleasant feature: they can fall just as sharply. How ready you are for such a turn of events, how you will react to the loss of part of the investment portfolio is one of the main, perhaps even the most important factors that should be taken into account.
Take Special Tests It can be difficult to assess the level of your own risk tolerance on your own. You may simply have no idea how difficult it will be for you not to feel fear when the market fluctuates and to keep your peace of mind when part of your assets depreciate. In order to determine this factor, financial experts have developed special tests-questionnaires of financial risk tolerance. Answering the test questions, the investor presents his own emotions in various scenarios. The test takes into account such individual factors as age, income, marital status, level of knowledge about the investment market. Answering the questionnaire questions, the main thing is to remain honest, first of all to yourself. If you don't properly assess your willingness to take risks, the first failure can turn you away from investing forever.
Select Assets for the Investment Portfolio After you determine the planning horizon and the degree of your own risk tolerance, you can start choosing assets for the portfolio. There is a 5% rule in investing, according to which it is not worth investing more than 5% of its total volume in any asset in your investment portfolio. The most important thing in diversification is to choose assets with such an eye that their prices move in different directions in the historical perspective. By correctly distributing funds between assets, you will be protected from sudden market movements: when part of the portfolio loses value, the other will grow. If, according to the results of the risk tolerance test, you turned out to be a conservative investor, then the main part of your portfolio should be assets that are least exposed to risk — for example, US Treasury bonds. With a high risk tolerance, the portfolio can be based on various company shares. The key word is various; no matter how one company attracts you, be sure to diversify — no successfully growing startup is immune from collapse. Investors with the greatest risk tolerance can include digital assets in their investment portfolio — cryptocurrencies, stable coins, tokens of IDO/IPO projects. However, there should not be many digital assets in the investment portfolio — for example, Yale University experts do not recommend including more than 6% of such assets in the portfolio. Rick Edelman, founder of the investment company Edelman Financial Engines, believes that this figure should not exceed 1%.
What Cryptocurrencies Are Preferable for the First Portfolio? If we talk about what is preferable — bitcoin, stablecoins or tokens, then tokens are definitely the most unreliable investment tool. You can invest in them only if you are initially ready to part with investments that are a kind of lottery. If we talk about bitcoin, “digital gold”, as it is often called, then in fact this asset correlates with the movement of the stock market, so it can hardly be considered as a refuge from shocks, which, in general, has been demonstrated by the events of recent months. Of all digital assets, stable coins, for example, USDT, whose exchange rate is pegged to the dollar, will be the most reliable. In the investment portfolio, such assets can act as cash — they are easily and losslessly transferred to fiat, are present in the listing of any crypto exchange, and do not pose any difficulty when buying or selling. Be Sure to Rebalance Your Portfolio An investment portfolio cannot be compiled once in order to remain like this forever. Regularly audit the assets in the portfolio, because as time goes on, both you and the market will change. The degree of risk tolerance that you had in your 30s and 40s is likely to radically change by 60. The planning horizon will also be different. New assets may come to the market, some may become obsolete.
Rebalancing also involves maintaining a certain proportion of assets in the portfolio. If the shares of companies accounted for 15% in it and over time significantly increased in price, then despite the fact that the investments showed such positive dynamics, the share of shares in the portfolio will need to be returned to its original value. This need is explained by the fact that with an increased share of shares in the portfolio, its overall risk level will exceed what is acceptable for you personally. You can rebalance the portfolio by time — once a year, for example, or constantly monitor the percentage of the ratio of asset classes to each other and, if exceeded, for example, by 10%, redistribute them. If the rebalancing is carried out on time, then you should not do it more often than once every six months. If the rebalancing trigger is exceeding the threshold value, then 5% is considered the optimal value.
Do not React to Market Panic A crisis is a normal phenomenon that the market necessarily goes through every few years. If your portfolio is rapidly losing its value, it is difficult to remain calm, but investors should not give in to panic and start selling their assets for a song in horror. It is to protect the portfolio from loss of value that all the previous steps are aimed at: having done them correctly, you will be sure that you will withstand a period of turbulence — all assets in your portfolio, provided they are correctly selected, cannot exactly depreciate. It should be remembered that panic moods and the subsequent sale of assets on the market are often irrational — unsystematic investors who build their portfolio on highly speculative assets often interpret news rumors in their own way, without understanding their essence, react to information stuffing, and attempt manipulation.
At the moment when they simultaneously sell off assets, they bring down liquidity in the market. It will take a little time, and the market will return to its place, but alarmists will not be able to return either the nerves spent or the money lost. Long-term investors are more financially educated, select assets according to science and therefore remain calm amid the storm. They know their portfolios are designed not for one day, but for many years, that they are protected from depreciation due to a competent asset allocation, that the degree of risk is precisely measured. So they calmly wait for the end of the panic period. It is this approach that allows you to win in the long run.
Author name: Albert Galeev
Quickex.io partner writes