What is diversification?
In crypto, diversification refers to the distribution of capital in different types of coins and tokens to reduce the overall risk. It involves combining a range of strategies to create a portfolio made of a wide range of assets.
Learning how to balance risk and limit losses is an important part of investing in such a volatile market.
Diversification is especially important when an investor aims to profit from projects that are still in the early stages of development.
How to diversify
By having a portfolio that is diversified between 8 to 10 different assets, the risk of failure is spread out. If one project fails to meet expectations and ends up being a poor investment, the loss is limited to the capital allocated to that particular asset.
An investor may choose to invest in some high-growth, high-risk assets (that pay off well in bull markets) as well as some lower-risk, lower-reward assets (which won’t suffer as much during bear markets).
If someone invests all of their capital into a single asset, they under-diversify and may experience a loss, even if the rest of the market is on the rise. In a diversified portfolio, positive performing assets tend to neutralize those with poor or negative returns.
Consider a portfolio where 10% of the total capital is allocated to 10 different assets. If one asset goes to 0, the total loss is 10%. But, if that asset gains 300% (which is a reasonable gain for a crypto asset during a bull run), the investor has made a 30% portfolio gain with a maximum worst-case of 10% risk (assuming the price of the other assets stays the same).
The main reason for diversification is that nothing is certain in financial markets, no matter how confident an investor is about a particular investment.
Note that it is also possible over-diversify. If an investor invests in too many assets, returns will be minimal as the capital is too thinly spread.
