Risk diversification in cryptocurrency

There are different opinions on how to perceive the situation that prevailed in the crypto market from November 2017 to January 2018. Some call it an economic bubble or mass hysteria, but it was an oasis for investors. Crypto-assets were all skyrocketing, and many market participants didn’t even seem to try to question which of their complex risk-management strategies to choose. The only question for them was how many coins they needed to buy to become a millionaire as soon as possible.

But soon the euphoria gave way to a prolonged bear market, and the question of how to minimize risk by investing in what were still promising assets came to the fore. No one wants to lose money on the next sharp drop.

The crypto market goes through the same cycles as any other market. And even though the mass hysteria around Bitcoin has all but died down, cryptocurrencies are still a very promising investment asset class. In my opinion, the best strategy for long-term investing in crypto assets is still to buy when their price is relatively low and hold them for a long time. But to avoid losing all your savings because of one or two mistakes, you need to have a good risk management system in place.

In recent years, during the mass popularity of cryptocurrencies, we have seen many examples of people losing their money because of a poor understanding of the market, participation in fraudulent schemes, or simple randomness. There is a lesson to be learned from these mistakes.

One of the most basic investment strategies that take into account all of these risk factors and seek to maximize potential returns is investment portfolio diversification.

Diversification is a strategy of compiling an investment portfolio of many assets. A portfolio that includes many different financial instruments is considered more stable than one consisting of only one asset. And in most cases, a diversified portfolio provides the owner with a higher return with less risk.

You can diversify your portfolio between assets of different classes or within a single class. For example, diversification between fiat money and cryptocurrencies is diversification between different asset classes, but if the portfolio consists of, say, bitcoins and others, it is diversification within one asset class.

Traditionally, one of the main requirements for a diversified portfolio is to include many different assets that are not positively correlated with each other. In this case, if one of your assets loses in value, the price of the others will either remain stable or rise, covering the losses and ensuring the stability of your investment portfolio.

This is where the difference between diversification between traditional financial assets and cryptocurrencies lies: popular cryptocurrencies are highly correlated with Bitcoin, which determines the overall trend for the cryptocurrency market as a whole. This is seen in the charts below.