Modern portfolio theory teaches not to put all your investment eggs in one basket in order to diversify returns and weather the ups and downs in markets. While allocating a crypto portfolio shares similar principles to allocating a portfolio of more traditional assets like bonds, stocks, and real estate, there are differences.
Common methods and principles many cryptocurrency investors use to facilitate their crypto-asset allocation are to buy cryptocurrencies of different market capitalization, diversify by the geographic location where a cryptocurrency or cryptocurrency project was created, and invest in different types of cryptocurrencies with different use cases.
Crypto investors should be careful not to put all their investment eggs in one cryptocurrency basket, so asset allocation is important.
Common ways to diversify by market capitalizations, geographic location, and different types of cryptocurrencies with different use cases.
Asset allocation reduces the overall volatility but doesn’t eliminate systemic risk.
The ultimate goal of diversification is to reduce the volatility of the portfolio by offsetting losses in one digital asset with gains in another digital asset.
Therefore, when a crypto portfolio is well-diversified, ideally, investments with a strong performance compensate for the negative results from poorly performing investments.
However, diversification does not usually affect the inherent or systematic risk that applies to the cryptocurrency market as a whole. Hence, it is important for you to decide on your risk tolerance, financial goals, and timeframe to decide how much of your investment portfolio can be allocated to cryptocurrencies.
Different Market Capitalizations
A valuable principle to follow when constructing a cryptocurrency portfolio is to invest in cryptocurrencies with a range of market capitalizations. In other words, invest in cryptocurrencies that have small market capitalizations, cryptocurrencies that have medium market capitalizations, and cryptocurrencies that have large market capitalizations.
What is Market Capitalization in Cryptocurrencies?
Market capitalization is a term borrowed from the equity markets. In traditional stocks, market capitalization is the most recent market value of a company’s outstanding shares.
In cryptocurrencies, market capitalization is calculated as the amount of a digital asset outstanding multiplied by the price of each one of that asset. For example, based on the historical high price that Bitcoin has achieved of around $68,000 each and roughly 19 million or so BTC mined, its total market capitalization at the peak of the Bitcoin market was $1.3 trillion.
How Should You Allocate by Market Capitalization?
The specific weighting that an investor would assign to small, medium, and large market capitalization cryptocurrencies depends on the investors’ risk preferences and goalsfors their portfolio.
Investing heavily in small market capitalization cryptocurrencies would present the most portfolio volatility out of the three options. However, there is also the possibility of incredibly high returns if one of the small market capitalization cryptocurrencies takes off.
On the other hand, investing in large market capitalization cryptocurrencies would present the least volatility out of the three options; however, this may come with a lower expected return.
The typical investor constructing a portfolio with their risk tolerance and investment horizon in mind would typically spread their allocation between small, medium, and large market capitalization cryptocurrencies or a higher weighting on the large market capitalization cryptocurrencies.
Another Benefit – Liquidity
By allocating your digital asset investment by market capitalization, you may realize another benefit, that being liquidity. Liquidity in cryptocurrency means the ease with which a digital currency or token can be converted to another digital asset or cash without impacting the price and vice-versa.
Since a larger market capitalization cryptocurrency is more likely to be more liquid, an even allocation across some larger capitalization cryptocurrencies, such as Bitcoin or Ethereum, benefits investors should you ever need to sell part of your cryptocurrency portfolio to deal with cash requirements.
Location of Creation
Another tool used in crypto-asset allocation is to invest in cryptocurrencies with different geographical locations from where the project originated.
It may be difficult to understand where a cryptocurrency project is created. However, many large and popular cryptocurrencies and cryptocurrency projects disclose where the coin or project was made and where it is currently operated, but you can find this in the whitepaper for the cryptocurrency.
It is important to diversify with respect to geography because of the government regulations that surround cryptocurrency. Some governments are quite friendly towards cryptocurrency and don’t have many or any regulations around cryptocurrencies. However, some jurisdictions have very tough and stringent cryptocurrency regulations, which could significantly impact the price and returns of a cryptocurrency.
Thus, it can be seen as a very valuable tool to have diversification of where the cryptocurrency originates or is operated when constructing a cryptocurrency portfolio.
Different Types of Tokens
When allocating a crypto portfolio, you may also want to spread your investment across cryptocurrencies that are built off different blockchain technologies.
For example, you might want to consider the four main types of cryptocurrencies:
Payment Cryptocurrency – A pure peer-to-peer electronic cash to facilitate transactions
Utility Tokens – A utility token serves a specific purpose or function on the blockchain, called a use case
Stablecoins – Stablecoins are designed to provide a store of value as they can be exchanged for one or more fiat currencies.
Central Bank Digital Currencies (CBDC) – A cryptocurrency issued by the central banks of various countries in token form or with an electronic record and pegged to the domestic currency of the issuing country or region
Allocating a portion of your cryptocurrency to each type of digital coin helps to take advantage of the benefits different blockchains provide and to have an additional aspect of diversification in the crypto portfolio.
Thank you for reading CFI’s guide to Cryptocurrency Portfolio Allocation. To keep learning and developing your knowledge base, please explore the additional relevant resources below: