Course 3.3: Building a Diversified Portfolio

Introduction

Responsible, strategic crypto investing, requires a diversified portfolio. Diversification in your crypto assets is essential to mitigating risk while increasing your long-term growth. This strategy epitomizes the common saying:

“don’t put all your eggs in one basket.”
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There are multiple factors to consider as you build your portfolio. You can optimize your returns by learning to assess risk and use the most advantageous allocation strategies for your goals. So today, let’s learn how to diversify your cryptocurrency investments and balance risk vs. reward properly.

Asset Allocation Strategies for Cryptocurrency Investing

Diversification allows you to minimize price volatility - and therefore, risk - in your crypto investments. It’s a fundamental principle in investing, and with cryptocurrency being an especially volatile industry, it becomes even more important. 

What is asset allocation?

Asset allocation describes the process of dividing your portfolio amongst multiple cryptocurrencies. There are many asset allocation models you can choose from. Each has its benefits. 

For example, A traditional investing model splits funds between well-known, mostly stable assets of various classes, such as S&P 500 stocks, bonds, or real estate. These assets are relatively low-risk, and generally held long-term. The crypto equivalent could include splitting your investments between the most widely adopted cryptocurrencies, like Bitcoin and Ethereum. Then, simply hold it in your digital wallet for multiple years - waiting to profit from its long-term growth. 

Crypto asset allocation models are specific to the characteristics that cryptocurrencies, as digital money, have. For example, you can divide investments between: 

• Crypto utility tokens 
• Crypto gaming tokens
• Crypto non-fungible tokens (NFTs)
• Various crypto use cases or industry focuses
• Cryptosystems/consensus mechanisms (ex. Proof-of-work vs. Proof-of-stake)
• Pegged cryptocurrencies
• Crypto futures
• New crypto projects

All of the above serve unique purposes and operate in different ways. Cryptocurrency is also advantageous because you don’t have to own crypto outright, reducing your risk. For example, with crypto futures, you ‘own’ a prediction of the crypto’s market value. If you’re correct, you profit!

You don’t need to invest in every asset class and crypto type - choose those that have the most potential reward for your specific investment strategy and goals. Analyze their predicted performance and balance their risk vs. reward. 

Balancing Risk and Reward: Large-cap vs. Mid-cap vs. Small-cap Coins

When searching for new crypto investments, it’s helpful to understand how their unique characteristics affect their predicted risk vs. reward. A major indicator of a cryptocurrency’s risk-reward profile is its market capitalization (cap). This refers to the amount of cryptocurrency in circulation, or its total supply. 

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Most crypto will also slowly release its supply into circulation so it has a long-term potential to grow in demand. You can use the CoinMarketCap site to track market caps. You can divide crypto into three main market cap categories:

Large-cap: Cryptocurrencies with a large market cap include Bitcoin and Ethereum. Ethereum’s market cap is four times larger than any other existing crypto! Larg-cap cryptocurrencies are usually more stable, with a huge user base and long history. They present lower risk but also may provide lower returns. 

Mid-cap: Mid-cap cryptocurrencies are more volatile. However, they offer higher returns. These crypto fall between a market cap of $1 billion and $10 billion, so many may still have large user bases and established use cases. Tezos (XTZ) is an example of a mid-cap crypto.

Small-cap: These cryptocurrencies have more untapped, unexplored potential. However, they’re also much riskier to invest in. With a smaller supply, there is a higher chance they will fail. However, they also represent a shining opportunity for explosive growth.

When building your portfolio, invest in different market cap categories. Classify each crypto’s market cap, and track its growth (or decline). Try to keep your vulnerability to risk at a minimum, or a balance with your reward.

Portfolio Diversification: Including DeFi projects, NFTs, and Stablecoins

Aside from the standard cryptocurrencies and tokens, you can include DeFi tokens, NFTs, and stablecoins in your portfolio. Since each technology serves a unique purpose, this can also increase your returns.  DeFi (decentralized finance) is an ever-growing financial technology that’s extremely popular in the crypto sphere. 

1. DeFi

DeFi embraces the decentralized nature of blockchain technology, eliminating the usual need for an overseeing third party. For example, in a typical transaction with fiat currency between yourself and a friend, you must go through your bank to transfer the money. The bank must approve your transaction. With DeFi, all transactions are peer-to-peer, providing limitless autonomy and control over your account. 

While this technology is relatively new, it holds massive growth potential. The DeFi market in 2021 was valued at around $9 billion, and is expected to surpass $70 billion by 2030! This makes DeFi projects a great category to explore, especially for those personally interested in the industry.

2. NFTs

NFTs (non-fungible tokens) are another digital asset with huge potential. Non-fungible means irreplaceable, or that the asset is one-of-a-kind. NFTs can go for a wide range of prices and aren’t limited to digital art. There’s NFT celebrity memorabilia, 3D models, game items or skins, website domains, and more. NFTs may also have the potential to act as a license or certification for a skill.

3. Stablecoins

Another fantastic type of crypto to include in your portfolio is stablecoins. These are pegged to the value of another asset, such as the US dollar. This minimizes their volatility, making them very useful for daily transactions. 

Rebalancing Your Portfolio: Staying Flexible and Adapting

Creating a diversified portfolio requires regular maintenance. Once you’ve started your investment portfolio with varied cryptocurrencies and crypto-related projects, you must balance it. 

This means a balance between 

• types of assets, 
• degrees of risk and reward, 
• and market cap. 

Since these digital assets are dynamic - changing price in function and value - routine checking and re-analysis is wise. 

For example, say you’ve invested $1,000 between five cryptocurrency projects with different asset classes and market caps. You allocated $200 in each (Crypto A, B, C, D, and E). After one year, Asset A has increased in value to $700, while the rest of your assets have increased minimally. Your portfolio now holds a majority of Crypto A - so if it downturns, you risk losing much more. To rebalance, you could sell a portion of Crypto A, invest in a new cryptocurrency, or redistribute some of your investment funds. 

It’s recommended that you schedule your rebalancing to stay routine and organized. Depending on your investments, you may need a shorter or longer time between rebalancing sessions. For example, if you’re investing in multiple small-cap cryptos with higher volatility, it’s wise to review them weekly or monthly. Otherwise, you can stick to a quarterly (every three months) or bi-annual (every six months) basis.

Conclusion

Diversifying your portfolio is key to developing fruitful investments. In this guide, you’ve learned multiple diversification tactics, and how to keep your assets balanced routinely. These strategies will minimize risk, and help you achieve long-term growth in the long term. 

While it’s crucial to understand how to analyze potential crypto investments on your own, it’s advisable to consult with a financial expert. These professionals can provide you with more detailed insights, solidifying your investment decisions.