Education - Diversification, Portfolio Theory and Crypto
Don't put all your eggs in one Basket!
Seems simple and obvious but is it true and helpful? How does it relate to crypto?
Firstly, the definition (Investopedia): Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security. Portfolio holdings can be diversified not just across asset classes, but also within classes by investing in foreign markets as well as domestic markets. The idea is that the positive performance of one area of a portfolio will outweigh the negatives in another. Review:
1. Not a bad definition however, it claims that diversification leads to "higher long-term returns". I believe that is flat out wrong:
A) If we assume you average a bunch of investments with similar return expectations you will achieve an average outcome. Adding more investments does not improve performance but may improve fluctuations (volatility) of the overall portfolio.
B) The Warren Buffett thinking behind this is that you should never buy anything for the sake of diversification alone (Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance). Each asset you buy should be only purchased if you have properly analysed it and have genuine conviction in your decision. If this is true, adding a new investment just for the sake of diversification just adds a poor investment to your good investments. That in turn leads to underperformance.
C) You can't have higher returns and lower risk under a fair market. Risk and Return are connected in that investors who invest in risky assets expect a higher return. If there was a safe asset that had high returns, everyone would buy it, its price would rise, and the asset would experience higher volatility and possibly future underperformance. In the end an assets returns are related to their risk, although some assets such as Bitcoin, could have a higher Sharpe ratio - meaning they are good value for their risk.
2. Diversification as a means to an end.
What are you trying to achieve?
A) I want to be a Billionaire and I am starting with nothing:
If this is your aim, diversification is the worst possible mistake. Diversifying your investments will provide safe and average returns guaranteeing that you will never become a Billionaire. If you want to go from Zero to Hero you actually need to risk everything on a single asset and be good (or lucky) enough to pick the asset that beats all the others. Look at the Billionaires that succeeded. Most have bet on something very specific. Elon has made it big on the back of Tesla's success, Gates on the back of putting everything in Microsoft, Zuckerberg into Facebook. These guys didn't diversify into other stocks as soon as their companies were worth something. They rode their success all the way and invested all their time and money on one project.
B) I am doing pretty well and I want to hold on to my wealth:
Diversification is your friend. If your aim is to make your wealth last you should be diversified and take advantage of the improved risk. If you have many investments it becomes unlikely that they will all fail and your returns are likely to be more stable.
C) I am working hard to save money so that I can invest and retire at 65.
Again Diversification will help (depending on your age and target income in retirement). Predictable returns will help build a financial plan and investment strategy so that you can retire at your goal age. Remember, you won't be a Billionaire but you won't retire broke either.
Crypto Diversification
When it comes to crypto the rules of finance still hold. Diversification has the same rules.
Having all your money in PotCoin may not be wise. However, diversification for the sake of it is still against Buffett's principles. You should probably not buy PotCoin or SafeMoon to diversify your Bitcoin without understanding it first.
Good Diversification is possible through taking profits on your successes. Below is a list of the best performers over the last year. Some of our clients hold HEX, ADA, FTM, SOL, DOGE and CHZ. If you are one of those you may want to consider diversifying those enormous gains by switching into BTC, ETH, FTT, SRM, BNB, HNT or any other good projects that are yet to have their run.
I've been through a few cycles now and I've seen many coins go from hero to zero. Don't be caught out.
* Not Personal Financial Advice
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