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What is portfolio diversification?

• What is diversification and why is it important?
• Types of diversification
• Advantages and disadvantages of diversification
• FAQs

Traditionally, the crypto market is considered to be quite volatile, that is, the value of assets on it can change quite quickly, including within one day, and sometimes even several hours. To protect themselves from possible losses, the experienced analysts advise to diversify your portfolio.

What is diversification and why is it important?

An investment portfolio is a set of all assets in which a particular investor invests his funds. These can be cryptocurrencies, stocks, bonds, commodities, index funds, precious metals, real estate and more.

All of these classes of the investment carry varying degrees of risk. For example, the crypto market is extremely volatile, and the value of assets here can change depending on various news by tens of percent within one day. In turn, the stock market is much more stable - there are jumps here, but they happen much less often than in the cryptocurrency market. For example, the last major crisis in the stock market occurred in 2008 and was associated with the US mortgage crisis, as well as the collapse of investment banks. Finally, bonds are the most secure and stable asset, especially when we are talking about bonds issued by a government, such as the US Treasury.

Other asset classes, such as commodities, may go through periods of both volatility and relative stability. For example, spot prices for natural gas showed relative stability for ten years, but at the beginning of the coronavirus pandemic in 2020 they fell to $47 per thousand cubic metres, and then two years later, against the backdrop of hostilities in Ukraine, rose to $3,000. Literally within one or two months, the cost of gas could change by 50%. This is a very serious volatility, but for this market for many years it was atypical. Similarly, for oil prices there are periods of sharp rise and the same sharp fall, but for several years the price level can approximately remain the same.

Portfolio diversification means that a trader invests in the assets with different levels of risk: simultaneously in stocks, bonds, cryptocurrencies and, for example, commodity assets. In this case, if one asset from the portfolio falls sharply in price, then the growth of others will help compensate or, at least, reduce losses.

Types of diversification

Depending on their own preferences, an investor can choose to diversify based on different principles. The first is diversification across asset classes, such as investing in stocks, bonds, and commodities. Secondly, diversification by country - a trader can buy shares in different countries, for example, invest in securities of companies from his country, as well as in the US stock market.

Finally, thirdly, diversification within the same asset class is possible. This is most clearly seen just in the example of cryptocurrencies. A trader can invest part of the funds in Bitcoin, part in Ethereum, and distribute the remaining parts among less popular Altcoins. The fact is that BTC is still considered the most reliable Cryptocurrency in the world and reacts mainly to changes in the world market, while smaller Altcoins allow to get additional profit due to sharp fluctuations in the exchange rate. A typical example is the rise of Dogecoin after the purchase of Twitter by Elon Musk.

Another benefit of diversification is increased liquidity. If necessary, selling Bitcoin or shares of the largest companies will be much easier than getting rid of less popular assets, for example, new Altcoins.

Advantages and disadvantages of diversification

The key benefit of portfolio diversification is hedging the risk. Essentially, the upside potential of some assets offset losses from others. Another important advantage is the ability to invest in a new class or type of assets. For example, if your investments are mainly in US government bonds, you can take a risk and invest in promising Altcoins without fear of losing the capital.

However, diversification also has its downsides. Firstly, a potential investor must keep track of several types of assets in which his funds are invested, for example, not only the crypto market, but also the stock market. Secondly, investing in different types of assets usually means that the investor has to pay more commissions.

Finally, thirdly, it is not easy to form a balanced investment portfolio; for this, an investor needs to accumulate a lot of experience in independent work. But in the long term, portfolio diversification, according to most analysts, justifies itself.

FAQs