With over 1,560 cryptocurrencies for investors to settle on from, the abundance can seem overwhelming.
But it also raises a stimulating question: How important is it to possess exposure to a variety of cryptocurrencies? Is it worth diversifying your holdings so as to mitigate risk? The work of Harry Markowitz might lead you to think so.
The Nobel Prize-winning economist, author of the classic 1952 article “Portfolio Selection,” devised modern portfolio theory (MPT), which stresses that diversifying assets is crucial. If you diversify enough, you'll make risk get away and obtain the mean. Time and time again, Markowitz’s research has shown that investors can assemble the right portfolio.
Indeed, recently published research by the Bocconi Students Investment Club at Bocconi University in Milan, Italy, showed that applying the MPT framework to crypto beat all other portfolios, at the value of a greater volatility.
The investment club wrote:
“Our findings, consistently with MPT, are that portfolio variance are often significantly lowered by exploiting low covariances between coins.”
In this way, it’s a validation of the thought that fifty to 60 percent of a crypto portfolio should be core holdings of the 2 largest coins by market capitalisation , bitcoin and ether. Alternatives, the thinking goes, should be added only after.
Jeffrey Van de Leemput, a co-founder of Cryptocampus, a crypto mentoring group, says diversifying your portfolio is extremely important. Not only will this mitigate risk but it also can substantially increase the reward factor of a portfolio.
“Personally, i prefer having 80 percent large caps and 20 percent small caps mixed certain performance,” says Leemput.
All go down together
But this risk mitigation strategy could also be hard to tug off in crypto. once we saw the worth of bitcoin plummet earlier this year, it dragged all the opposite cryptos’ prices down too.
Hence, some afflict Markowitz’s theory, or a minimum of its applicability to the brave new world of cryptocurrency.
Dejun Qian, founding father of the FUSION Foundation, a public blockchain project, says diversification could help to extend the likelihood of finding an honest bet. He warns that during this market, 90 percent of the projects will die within the future. Diversifying will help us to capture that 10 percent.
The fun part is looking for those golden nuggets – the initial coin offering (ICO) tokens and little caps that you simply believe will have the potential to achieve the end of the day . But in most cases, diversification doesn’t help with limiting risks because cryptocurrencies have repeatedly entered periods where they move in tandem, Qian said.
And it bears repeating that during this market the danger is high and crypto investing isn't suitable for each investor. Do your own research.
That includes a minimum of entertaining the arguments of so-called maximalists, who claim that there can only be one winner in cryptocurrencies (whichever one they’ve invested in, naturally), because money relies on network effect.
Maximalists are often rude and clannish, especially on Twitter, but that doesn’t mean they’re wrong. And if they’re right, diversification is simply “spraying and praying.”
Then again, stocks and bonds aren’t riskless either, and even some Wall Street analysts say crypto itself could function a diversification play for mainstream investors.
JP Morgan strategist John Normand examined the potential role of cryptocurrencies in diversifying a worldwide portfolio during a 71-page research report on cryptocurrencies published in February.
“Given both their high returns over the past several years and their low correlation with the main asset classes, offsetting a number of the value of high volatility. If past returns, volatilities and correlations persist, CCs could potentially have a task in diversifying one’s global bond and equity portfolio.”
Qian observes that we've seen the market cap of cryptocurrencies soar from no quite $1 billion to $700 billion early this year (though it had been right down to $329 billion at the start of June). nobody can deny this market is becoming more and more important. But it remains very small compared to the fiat currency market.
“Along with this exponential growth, having some cryptocurrencies in someone’s investment portfolio not only can help him catch the return from this booming but can also help him to know more about this new world,” says Qian.
Summing up, Markowitz’s MPT is for risk-averse investors.
It is a well known investment strategy which guides investors to mix a portfolio of assets with returns that aren't always positively correlated so as to lower portfolio risk without sacrificing return. But be warned that crypto isn't yet a mature asset class and hugely volatile therefore correlation and patterns are difficult to predict.