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Asset Allocation: Why It Is Crucial to Diversify Your Crypto Portfolio

The success of an investment portfolio is largely dependent on asset allocation. Find out how to effectively allocate your crypto assets to reduce risks and grow your wealth.

If you are involved in investment of any sort, diversifying your portfolio is crucial to hedge against the risks involved. It means that you have to invest in different kinds of assets in such a way that the growth of others will balance out possible deprecation of some of them, and in the end, you will still end up with a profit.

There are two levels to portfolio diversification:

  1. Investment in different sorts of assets.
  2. Allocation of same-type assets.

For example, on the first level, you may invest in stocks, bonds, real estate, art, and crypto. On the second level, you choose which stocks and bonds go to which fund, make sure to have various sorts of real estate, buy pictures by both promising and renowned artists, and have numerous different crypto coins. That’s what asset allocation basically is.

In this feature, we shall look at asset allocation in crypto, talk through typical techniques and risks involved, and cover other important issues relevant to the case.

The Importance of Asset Allocation

Asset allocation is a crucial part of investment strategising, with some research suggesting that over 90% of the difference in the performance of two portfolios comes down to it. Even conservative estimates place it as one of the most important factors influencing the success of a given portfolio.

Finding the blend of assets that perfectly matches your needs might take time but is always possible. In most cases, it comes down to your risk appetite: the bigger the share of high-risk assets in your portfolio, the higher are your potential gains or losses. Still, a sensibly built portfolio is a great way to hedge against losing all the capital.

Over the recent years, crypto has been gaining steam as a legit part of an investment portfolio, as it promises higher returns than traditional investments. For reference, over the past year, the returns of S&P 500 is at 33%, while Bitcoin is at 245%, with the Cryptocurrency LargeCap Index (consisting of cryptocurrencies with the largest market capitalization) at 302%.

Return comparison chart of S&P 500, Bitcoin, and Cryptocurrency LargeCap Index
Image taken from S&P Global, tracking S&P 500®, Bitcoin Index, Cryptocurrency LargeCap Index

The high profitability of this new asset class makes its inclusion reasonable and desirable, while the ongoing regulatory recognition and technological advancement of the entire blockchain industry promise even higher yields in the future. Crypto platforms offer a wide range of crypto-asset types whose varying properties give one a multitude of investment options to choose from or combine.  

While the reasonable share of crypto in a portfolio varies from 1% to 30% depending on your risk appetite, it is sensible to start with smaller amounts if you are new to it. If you dedicate only a small fraction of the entire basket of assets to crypto, you will be able to see how it performs over time and make your decisions accordingly. Gradually increasing the invested amount—say, by reinvesting the profits—you could sensibly expand the crypto part of your portfolio.

Asset allocation in crypto is as important as in traditional finance, so even going for 1% suggests that there should be different kinds of crypto in your portfolio. And this begs the question: how do I start?

How to Add Crypto to My Portfolio?

Unless you deal in really big money, in which case OTC (over the counter) trading would probably be your best bet, you simply go to a cryptocurrency exchange and buy the desired amount.

Your best option would be to research the most prominent exchanges in the industry, compare their offered terms and conditions, and check their regulatory status. Here are some questions you should ask while doing your research:

  • Is the exchange regulated in a financially respectable jurisdiction like the US or the EU, or is it an offshore venture?
  • Are the exchange fees too high or suspiciously low?
  • What is the exchange’s daily turnover?
  • What cryptocurrencies are tradable at the exchange?

Unless you have a very high risk appetite, the most reasonable way would be to work with an exchange recognised under US or EU laws that claims reasonable fees, has a daily turnover of billions of US dollars and keeps away from dubious cryptocurrencies, mostly focusing on top ones. There is a selection of exchanges that fit those criteria, and working with them ensures you will not have much trouble with banks or tax authorities.

Crypto Investment Strategy #1: HODLing

Once you have bought your crypto, there are several options as to what to do next. The first is so-called ‘HODLing,’ a crypto term that means that you hold on to your crypto assets for years in the hope that they eventually will grow more expensive. You don’t have to do anything except be patient. This strategy worked great for those who bought Bitcoin at its lows. Still, there is not even the slightest guarantee that this strategy will work as intended, and regular returns are out of the question, too. Plus, the dramatic market swings seeing Bitcoin lose half its price over a couple of days require that you have nerves of vibranium to keep HODLing. But while the risks are enormous and the tension is sky-high, so are the potential profits. Or losses.

Crypto Investment Strategy #2: Trading

You could also use your crypto to engage in daily trading at an exchange of your choice. The process is similar to trading stocks or commodities yet the risks are higher due to crypto volatility. Additional risks come from the fact that crypto trading might be banned or frowned upon in certain jurisdictions, as well as the history of crypto exchange failures. This is arguably the riskiest strategy of them all where potential gains are enormous, but so are potential losses. The golden rule of trading is to never put at stake more than you can afford to lose.

Crypto Investment Strategy #3: Yield Farming

Finally, there is yield farming, a process mostly associated with DeFi crypto platforms. In this case, you use your funds as a loan to provide liquidity to the platform in exchange for rewards coming from trading fees. The model is risky as well. For example, those loans are susceptible to losses caused by smart contract bugs, hacks, the organiser’s dishonesty, or abrupt market swings. Being a form of passive income with potentially high returns, yield farming still requires serious crypto experience from the investor.

To remove the risks from the equation to the maximum possible extent, one may use their crypto  for gaining steady passive income that might not be as high as from lucky HODLing or yield farming, yet way more expectable and regular. 
Effectively it means transferring the crypto investment to an experienced entity, such as Cabital, that would ensure steady return while mitigating risks within reasonable constraints. As mentioned in another post, Cabital does not place a lower limit on your investment, so you can test the waters with small sums of USDT on the 7 Day Fixed Savings plan with 12% APY.

Table 1. Comparison between the ‘Depositing’, ‘HODLing’, ‘Yield Farming’ and ‘Trading’ strategies
Table 1. Comparison between the ‘Depositing’, ‘HODLing’, ‘Yield Farming’ and ‘Trading’ strategies

Diversify Crypto Portfolio to Mitigate Risk

Bitcoin alone can showcase what mind-boggling volatility can be. Yet, crypto is not just Bitcoin. There are also Ethereum, BitShares, Tether, Ripple, DAI, and lots of other notable crypto assets. If you invest just in one cryptocurrency and it tanks, there is little you can do about it except to concede sadly. But if one crypto-asset in your portfolio plummets then having others on hand can save you from losing overall

The more crypto-assets you get, especially those considered blue chips of their realm like Bitcoin and Ethereum, the better off your portfolio is in mitigating the crypto risk. Besides investing in more typical cryptocurrencies, you can also invest in stablecoins, which offer higher interest rates due to market demand. 

It is similar to buying stocks in the same industry: even if some of them fail, others will prevail and cover for all the collateral losses. In a similar fashion, the risk commonly associated with crypto is spread out across multiple assets and thus mitigated, though not removed altogether. 

What Cryptocurrencies Should I Use to Diversify My Portfolio?

A diversified crypto portfolio with reasonable asset allocation would include different kinds of cryptocurrencies. While there are numerous ways to classify them into various groups, such as the extent of their centralisation, their consensus algorithm, or backing, in terms of investment, the most fundamental criteria are their economic foundation and financial performance over the years. Generally, there are three viable options of how to diversify a crypto portfolio.

Stablecoins

As we discussed earlier, stablecoins are cryptocurrencies pegged to or collateralised by other assets to keep their price stable, hence the name. In terms of crypto-asset allocation, their features include:

Price comparison chart of Bitcoin, Ethereum, and Tether
Graph generated with CryptoCurrencyChart.com
  1. They are the most stable crypto option out there: the asset’s steady price ensures hedging against crypto’s volatility, especially in the bear market. While typical cryptocurrencies like Bitcoin and Ethereum have drastic gains and losses, USDT remains stable, keeping its value of US$1.
  2. They are arguably the perfect gateway coin for those new to crypto, showcasing all the advantages of cryptocurrency without exposing its users to significant financial risks.
  3. Stablecoins like USDT are commonly used to service cryptocurrency trading and serve as a safe store of value, so they have a high demand in the industry. Thanks to their role in the industry, depositing them in a savings account at a company like Cabital can net you an interest rate almost ten times as high as in banks with minimal risk.

Bitcoin and Ethereum

Bitcoin and Ethereum are the world’s largest cryptocurrencies in terms of market cap, with the latter initially devised as an improvement over the former. As part of a cryptocurrency portfolio, their features are as follows:

  1. Bitcoin and Ethereum can be volatile therefore they entail higher risks but also greater rewards
  2. Over the long term, their prices have been dramatically fluctuating but also growing.
  3. Putting them in a savings account returns a lower interest than stablecoins but higher than just HODLing over mid-term.

Tokens

Tokens are a type of cryptocurrency. They exist on the same blockchain as their mother cryptocurrency, but, unlike it, they are issued by a specific company or project for fundraising or governance. Historically, most tokens (though not all) are versions of ETH and circulate on Ethereum’s blockchain. Here are some important features of tokens one should keep in mind while you build or manage a crypto portfolio:

  1. As tokens represent a specific company or project, investing in them implies trust in the company in question.
  2. A token’s performance usually mimics the performance of its issuer, thus effectively making the tokens function as shares (which caused lots of regulatory problems to the issuers back in the day).

Regulated tokens are generally safer yet less profitable, and vice versa. Typically, a token is a riskier asset than a traditional cryptocurrency or stablecoin, as the value can tank during a crypto market downturn. Some savings platforms offer high APY through their platform token. These tokens can expose users to extreme volatility during the downtrend, where the promised yield generated won’t make up for the decrease in value.

Comparison of stablecoins, Bitcoin, Ethereum, and tokens in terms of investment efficiency
Table 2. Comparison of stablecoins, Bitcoin, Ethereum, and tokens in terms of investment efficiency

To minimise our investors’ exposure to risk, Cabital offers returns paid in in-kind currency. So if you invest in USDT, your returns will be in USDT (and likewise in the case of Bitcoin and Ethereum).

Dollar-Cost Averaging

Another important technique for asset allocation in crypto is dollar-cost averaging (DCA). It means that you patiently buy out portions of the asset of your interest over a span of time instead of buying the total amount at once. This way, as you have purchased parts of the resulting amount at different prices, the overall cost averages itself out, and asset price fluctuations have a smaller effect on your portfolio. 

This strategy works well with traditional assets and crypto, the only difference being the fact that prices in crypto vary over time to a far greater extent than those in the world of regular shares or bonds. As a result, pros and cons to this strategy manifest themselves in crypto way more vividly than in traditional finance.

The pros of DCA include:

  • Hedging against moderate price fluctuations
  • Generally, a safer way to benefit from the market in the long run

The cons, on the other hand, are as follows:

  • The strategy may cause one to miss out on a giant gain
  • In case of dramatic price fluctuations, hedging may become less efficient
  • Network fees may consume your interest earned, so keep that in mind when planning your DCA purchases 

Just as with any other investment strategy, this one is good when used in moderation.

How to Track Crypto Portfolio Performance With Cabital

If all those techniques and details seem a bit overwhelming, especially if you are new to crypto, fear not. Unlike other crypto apps, Cabital has a crypto portfolio tracker function that offers a simple way to track the dollar value of your investments without the need to download yet another app. By being able to see your P&L within the app, you’ll always know how much you’re earning on your crypto investments and whether you need to rebalance your portfolio to achieve your targets.

This article has been prepared by Cabital Fintech (LT) UAB  (the “Company”) and is general background information about some of the Company’s activities at the date of this presentation.

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