Diversification is an investing technique popularised by Warren Buffet.
The idea Buffet propagated was that a concentrated portfolio can give you the best returns if you're right, but it can also give you the worst returns if you're wrong. Since nothing is 100% certain in investing and there are always things outside of the investor's control, the optimal way to manage your portfolio is to diversify it.
Diversification Is Not Optimal for Everybody
Some investors reject Buffet's method and prefer to invest only as much as they can lose in an asset they really believe in, leaving the rest of their money in cash. Other investors got their hands on active trading and prefer to speculate or hedge using derivative products.
There is no right and wrong method in investing, every investor needs to choose the way of approaching the market that suits him or her the most.
So, while all the arguments against diversification are valid, it is still a comfortable way of portfolio management for many investors.
There is even a rule of thumb: The portfolio diversification method is probably a good fit for you if you find it emotionally difficult to handle the volatility of the assets you own.
Diversifying in Cryptocurrencies
Investing in cryptocurrency became the hot topic and appears to be a mainstay ingredient in many portfolios these days.
But if you focus mostly on crypto, diversifying your portfolio can be challenging.
With so many different currencies, it is easy to get overwhelmed when deciding which currencies to invest in. And then, when you decide, a sweeping fundamental event such as regulatory news can wreck all of your cryptocurrency holdings at the same time.
Therefore, for true diversification it is optimal to hold not only cryptocurrency but also legacy assets like precious metal, stocks or real estate. Among these options, it is best to choose assets that you feel comfortable holding and markets that you understand at least in a superficial way. Doing proper in-depth research before committing to an asset is absolutely crucial.
But even within your crypto, you can help your diversification a little bit too and choose multiple cryptocurrencies of different fundamental values and different potential valuations. Let us explain.
Cryptocurrencies and Their Fundamental Value
Each cryptocurrency was created with a use case in mind.
Some are meant as the digital currency used for fast cross-border payments, some are designed as the oil that supports the functionalities of digital platforms. Yet other cryptocurrencies are created simply as a vehicle for speculation.
This ideal use case makes up much of the cryptocurrency's fundamental value.
There are more refined aspects to consider, such as how sound a token's use case is at all. But when you want to diversify, all you need to think of is picking several cryptocurrencies with different fundamental values.
This method requires a lot of research. In the DeFi era, it is also necessary to understand the technology behind each cryptocurrency. One thing that remains constant is that when diversifying investments through fundamentals, you should definitely avoid tokens that are only intended for baseless speculation.
Startup Thinking in Crypto: Potential Valuation
Another angle of approaching the diversification problem is looking at the potential valuation.
This way of thinking was taken over from the startup industry where potential valuation of a company is more important than its actual profits. It might make sense to judge projects in this way as long as you are considering very innovative blockchain projects that are just starting out. Remember though that such investments are extremely high risk, just like startup investing.
One good indicator of whether a blockchain project is worth investing in is its company's location. The number of users of a crypto project depends greatly on its location, size of target audience and quality of marketing. Keep in mind that a project native to a country that already uses cryptocurrency extensively may succeed faster than an equally good project in a country where the public is still somewhat afraid of blockchain technology. Faster adoption brings in more users who purchase the token, which then drives the token's price up.
An indicator that can on the other hand damage the potential valuation of a new technology project is its potential to be abused by cyber criminals. This leads to regulatory hurdles and stunted development of the crypto project.
To sum it up, let's reiterate that effective capital allocation requires a system to determine which investment projects or assets are less risky than others.
It is a good idea to aim for diversified capital allocation in your portfolio if you want to minimise the volatility of your total net worth. If you have no problem with volatility, simply choosing only the assets you most believe in may be a better approach for you.