How to Diversify Your Crypto Portfolio and Limit Risk

MORITZ PUTZHAMMER

19 August 20228 min read

Table of contents

Variety isn’t only the spice of life. It can also protect your investment portfolio.

Everyone knows that the cryptocurrency market can be extremely unpredictable, which is why the trading strategy that you select can significantly impact your investments. Safeguarding your bottom line in a volatile crypto market requires effective risk management.

Diversification is one of the core concepts of investing, one that significantly lowers a portfolio's risk. By diversifying your crypto portfolio and routinely rebalancing your assets, you are more likely to protect your assets and earn profits. Luckily, there are various ways to diversify your crypto portfolio, depending on your level of risk tolerance, and we’ll explore a number of them in the following article.

Why Is Portfolio Diversification Important?

Diversification is a strategy that involves spreading your investments across different types of assets. Instead of buying only crypto or gold (for example), you allocate certain percentages to certain assets within your overall portfolio. By taking this approach, you limit risk and reduce volatility, thereby making your portfolio more stable. If you hedge your bets and invest heavily in Cardano, thinking it will be an Ethereum killer, but the price plummets, then your portfolio will plummet along with it. In simple terms, diversifying your portfolio ensures that you don't lose everything at once if one type of investment goes down in value.

Diversifying your crypto portfolio involves spreading your investment across multiple coins, tokens, or projects. Investing in a single cryptocurrency can be risky, too, even if you decide to invest in the best cryptocurrencies such as Bitcoin and Ethereum. Both have experienced significant price swings over the past year and will likely continue to experience similar movements in the future.

For example, Bitcoin's price grew substantially in early 2021 when Coinbase went public, with speculations about BTC’s imminent institutional adoption growing as well. A few months later, though, that positive outlook abruptly changed following growing attention to Bitcoin's energy use and subsequent carbon impact, with critics pointing out that it is far from being one of the most energy efficient cryptocurrencies.

By putting all of your (crypto) eggs in one basket, you risk losing the value of your entire portfolio due to a one-off event such as a market crash, crypto winter, or even something as mundane as an unforeseen crypto malware attack. If you spread your investments across different coins and tokens, you will be less exposed to the consequences of a negative news event or market downturn, enabling you to weather the storm and continue to grow your portfolio.

How to Build a Balanced Crypto Portfolio

A well-balanced crypto portfolio can help your investments achieve optimal results. In the following sections, we’ll discuss how you can build a diversified and balanced crypto portfolio that will ultimately minimize risk and enhance your long-term profits.

Invest in crypto with different use cases

Cryptocurrencies have many different real-world applications aside from serving as a store of value or a way to buy and sell goods and services securely. There are currently over 12,000 cryptocurrencies and the number of tokens continues to grow at an extraordinary rate. The disruptive power of FinTech, with its emphasis on automation, as well as the promise of blockchain technology, which is fueling the growth of decentralized finance (DeFi), have led to a wide range of use cases outside of traditional financial transactions. Although the current crypto forecast is cloudy, the future of cryptocurrency is a bright and sunny one.

Numerous types of cryptocurrencies exist, each with a unique set of use cases. For example, while some coins are intended for payments, others are more involved with supply chains, smart contracts, privacy, governance, and cross-border payments,among other things. For instance, Bitcoin was developed as a virtual currency, while Ethereum offers smart-contract capabilities that enable the development of digital applications (dApps). Other altcoins, such as Ripple (XRP), were intended to make money transfers easier than in financial institutions like banks.

Nevertheless, investing in cryptocurrencies with different use cases and purposes requires extensive research into several areas, including crypto values, historical trends, and potential growth. Since each crypto project has different underlying foundations and technologies, you should choose a cryptocurrency based on how well it matches your investing goal. Some coins might be familiar to you, while others will be new cryptocurrencies to add to your portfolio.

Another option for investors is to allocate a portion of their portfolio to stablecoins. Stablecoins like USD Coin (USDC) and Tether (USDT) have a value anchored to an underlying asset like fiat currency, and they reduce the cryptocurrency market's volatility. In addition, you can lend them out for a high-interest rate and let them operate as a high-yield savings account so that your portfolio will still earn profits, even in a bear market.

Diversify by market capitalization (small, mid, and large caps)

The market capitalization, or market cap, is a reliable indicator of a cryptocurrency’s security. It is computed by dividing the total number of coins in circulation by the price at which one coin is currently traded. In general, the higher the market cap, the safer the cryptocurrency. As such, you may want to allocate a good portion of your portfolio to cryptocurrencies with large market capitalizations since they have strong potential.

The top two cryptocurrencies by market cap are Bitcoin and Ethereum, with the latter designed initially as an enhancement to the former. Compared to the other large-cap cryptocurrencies, they are quite well-established, and every crypto investor should consider holding some of each. Another thing to bear in mind is that the value of BTC and ETH often determines the price movements for many altcoins. In other words, there is a positive correlation between the price of Bitcoin and the price of many altcoins.

While a coin with a higher market capitalization is more stable and may have more solid fundamentals, a cryptocurrency with a small market cap could experience rapid growth. As such, there are many other coins with various market caps that you may want to consider. In general, mid-cap cryptos, or any top 10 to 50 cryptos by market cap, often have market caps between $1 billion and $10 billion. A low-cap cryptocurrency is one that has a market cap of less than $1 billion or is not in the top 50 by market cap.

Considering the way the crypto market is growing, mid-cap cryptocurrencies can be very profitable investments, especially if you do your research and establish whether or not they have the capacity to develop following market demands.

Diversify by investing in crypto projects in different countries

Selecting cryptocurrency projects from various regions can expose you to a broader range of innovations within the industry. And because cryptocurrencies are a worldwide phenomenon, diversifying based on where they are popular could lessen the impact of regional price fluctuations.

Investing in projects within regions with more openness for crypto investments may be more efficient and economical. For instance, Portugal is seen by investors as both a crypto hotspot and a tax haven. El Salvador was the first nation to recognize Bitcoin as legal tender, and they intend to build a "Bitcoin City" that will be tax-free and run entirely on digital assets.

Ensure that not all of your assets are tied up within the same country or region. To guarantee this, you must thoroughly research how various crypto projects perform globally as well as comply with all regulatory requirements to which you are subject. Doing so will allow you to balance your diversified portfolio even in unpredictable market conditions and become protected from regulatory uncertainty.

Last but not least, bear in mind that some governments have either imposed limits or outright prohibited cryptocurrency operations. Avoid investing in crypto projects where it is prohibited, and focus on places where crypto innovation is encouraged and therefore expanding.

Diversify by industry

You can also diversify by owning cryptocurrencies and their respective blockchains that are used in various industries or sectors.

Industrial uptake of blockchain technology, the technical foundation of crypto, has been swift, with the benefits of blockchain being realized by companies in a wide range of industries, including automotive, banking and financial services, government, healthcare and life sciences, insurance, media and entertainment, retail and consumer goods, and telecommunications, among others. The use of cryptocurrency in the gaming industry has exploded. Additionally, more and more users are trading digital assets on a global virtual marketplace.

If cryptocurrency maintains its current rate of growth, a small number of projects will invariably end up controlling a sizable amount of the market within their respective industry. However, you should Invest in cryptocurrencies that address real-world problems, which will lessen your exposure to unpredictable speculation. Also ensure that you thoroughly research both established and emerging industries before deciding on a coin or coins in which to invest.

Divide your investments in your portfolio by risk levels

Your risk tolerance should serve as your guide when it comes to diversifying your crypto portfolio. You can also use the same guidelines that govern asset allocation in a conventional portfolio in this scenario. What is best for you will depend on your risk profile, but there should still be a balance. Divide your investments into high, medium, and low-risk categories and assign the proper weights. Of course, a portfolio with a sizable percentage of high-risk investments is unbalanced. It may have the potential to give you greater gains, but it also may result in significant losses.

Start by adding more stable cryptocurrencies like Bitcoin and Ethereum to your crypto portfolio to help you control risk. You might then choose to include a smaller proportion of new, riskier crypto projects with different use cases. When investing in small-scale, high-growth crypto projects, try to invest a modest amount first. These projects may still be tied to the profits and losses of the broader cryptocurrency market, but, if successful, the incremental growth may increase the value of your portfolio as a whole.

Rebalance Your Crypto Portfolio Regularly

You will occasionally need to rebalance to maintain a diversified portfolio. Rebalancing aims to balance risks by adjusting the assigned asset weightings within a crypto portfolio. Investors do it regularly, and it simply entails purchasing or selling cryptocurrencies or other assets to achieve the desired level of risk or asset allocation.

The return to a level of risk that has been strategically chosen is the main advantage of routine portfolio rebalancing. Regular rebalancing is essential to acting within your risk appetite and maximizing profits, whether you do it once a day, once per week, or once a year. Once you've decided on the proportions you want to have in your ideal portfolio (e.g., 40/30/20/5/5), it's a good idea to periodically double check your portfolio to make sure that it is still following the specified allocation. The values of your assets will undoubtedly change over time, which makes occasional checking necessary.

As a risk management approach, traders might use portfolio rebalancing in conjunction with their current trading strategies. Additionally, portfolio rebalancing can be used as a stand-alone investment strategy and is frequently regarded as a viable substitute for “HODLing.”

Final Thoughts

Having a portfolio that lacks diversification is a risk that crypto investors cannot afford to take. It means that your investments are weighted toward one or two tokens, if the price crashes, then your portfolio will crash with it.

Rather, choosing to diversify your crypto portfolio means that you are taking a proactive approach to risk mitigation. Selecting different types of tokens (e.g., payments, security, utility, governance, and gaming) across a range a different industries (e.g., banking and financial services, government, healthcare and life sciences, insurance, media and entertainment, retail and consumer goods) throughout the world means that you are limiting the potential damage to your portfolio should things head south in the market.

And if you’re new to the crypto space, having a diversified portfolio also allows you to gain some exposure to this exciting, emerging market without bearing the full weight of its volatility. But always remember the golden rules when it comes to investing: do your own research and never invest more than you can afford to lose.