In 2021, as bitcoin and cryptocurrencies have become more of an acceptable asset class to many big investors and institutions, many retail investors might find themselves wondering if it’s worth having an allocation to crypto in their own portfolios.
Is investing in cryptocurrency worth it? Should crypto diversification be a part of every investor’s diversification strategy? Here’s a closer look.
What is Diversification?
Diversification involves spreading investments across different asset classes in an attempt to minimize risk and maximize returns. A diversification strategy often involves making investments across different sectors of the economy and within particular sectors.
The factors that make an asset good for portfolio diversification will vary depending on an investor’s existing holdings. One of the main goals is to ensure that if a particular sector or asset class takes a dive, the event won’t decimate the entire portfolio.
Ideally, a well-diversified portfolio will see gains in other areas when certain areas see corrections. In this way, downside risk can be mitigated even amidst the many unpredictable factors that come with investing.
Here are a few examples of assets that can be used to create diversification in a portfolio.
Real estate investment trusts (REITs) are tradable securities that give investors exposure to real estate. REITs also provide shareholders with a substantial portion of their income in the form of dividends.
Furthermore, there are different types of REITs, and these could provide even more diversification. Some REITs specialize in commercial real estate, like shopping malls. Others hold residential real estate like single-family homes, apartment complexes, and condominiums. There are even REITs for the healthcare industry and data centers.
Recommended: Pros and Cons of Investing in REITs
Exchange-traded funds (ETFs) can serve many purposes as part of an asset diversification strategy. There are ETFs for almost anything imaginable.
An ETF typically holds a basket of securities that aims to recreate the market performance of a particular index. Or the ETF could simply be a collection of top stocks in a particular sector, making it easy for investors to gain exposure without having to pick specific stocks. For instance, thematic ETFs focus on niche sectors like electric cars or artificial intelligence.
Recommended: Benefits of Exchange-Traded Funds (ETFs)
Gold is an asset that investors might diversify with. Other precious metals investments like silver, platinum, and palladium also fall into this category. Gold is what’s known as a “safe haven asset,” meaning people prefer it during times of uncertainty.
Holding gold can serve as a financial shelter during times when other asset classes see increased volatility or subpar returns. During the initial panic of early 2020, for example, gold performed well at a time when stock markets around the world witnessed historic corrections.
Gold is sometimes compared to Bitcoin when it comes to asset classes and diversification. Investors may consider both as a long-term store of value (though Bitcoin’s volatility makes it somewhat unstable in that regard), a hedge against inflation, and a non-correlated or less-correlated asset.
Recommended: Bitcoin vs. Gold
Asset Diversification With Crypto
One of the key reasons some market observers see crypto as a potential choice for asset diversification is because it sometimes isn’t correlated with other asset classes.
Bitcoin was positively correlated with the S&P 500, the benchmark index for U.S. equities in the fall of 2020. However, the correlation between the two dropped in February 2021, as the cryptocurrency market surged ahead. The 90-day correlation between the two dropped to 0.21 from a high of 0.5 in October.
Meanwhile, Bloomberg reported in May 2021 that some of the volatility of Bitcoin was spilling over into the stock market . A study by Singapore-based DBS Group found that S&P 500 futures contracts tended to post bigger swings after Bitcoin swung 10% up or down in the span of an hour.
How to Diversify a Crypto Portfolio
Once someone has learned the crypto basics and made the decision to diversify with crypto, they might then start asking whether or not they should diversify within crypto. In other words, should they invest in different types of cryptocurrency other than bitcoin?
The answer can be complicated and dives deep into what cryptocurrencies are and how they work. Bitcoin may be the easiest to understand as it only has one use case at present, and that is to serve as digital gold (a store of value) that can be easily divided and transferred among individuals (a medium of exchange).
Most other cryptocurrencies have myriad potential applications and tout themselves as being decentralized solutions. After learning how a crypto exchange works, investors are likely to be exposed to many different tokens.
Bitcoin vs. Smaller Coins
Bitcoin is the largest crypto by market cap and has the highest hash rate of any proof-of-work coin, making it the most secure network and the most liquid market. It was also the first cryptocurrency created and therefore has the longest track record. These features make Bitcoin the investable asset of choice for many large investors, despite the crypto’s ongoing volatility and extreme price fluctuations.
Smaller and newer crypto assets can see high returns in short periods, but their risk is also higher by several orders of magnitude. Many altcoins have seen their values plummet by 90% or more over time, with some going to 0.
Some courageous investors sometimes choose to speculate on the value of an altcoin’s alleged use case through regular crypto trading. These investors are similar to venture capital or angel investors who take on substantial risk for the hopes of finding a rare jackpot or “unicorn” project. This is an available option, but not one well-suited to the average investor with lower risk-tolerance.
Different Strategies for Crypto Diversification
Here are some ways investors can try to diversify within the crypto market:
1. Different types of crypto: Stablecoins, altcoins, Bitcoin itself–investors can seek coins and tokens that have different backgrounds and histories.
2. Different crypto market caps: Larger market-cap crypto tokens and coins include Ethereum and Bitcoin, but there are smaller ones, like Tezos, Aave, Theta, and more, that investors may also want to consider.
3. Different crypto industry focuses: Some cryptocurrencies focus on payment, others on video or the Internet. Investors can seek out different industry focuses.
While the cryptocurrency market is volatile and not suitable for every investor, there can be benefits to this market, such as periods of time when it’s less correlated to other asset classes and offers a form of diversification.
Photo credit: iStock/Eoneren
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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.