Whether you’re a cryptocurrency enthusiast or a capital market investor, you get to the point when you ask yourself if you’re actually doing things right. The price of Bitcoin may be valued $20,000 in the next couple of years, but is it enough reason to have all your eggs in one basket?
This is the reason why portfolio diversification is such a big deal to every investor. But which assets are actually worth putting your funds into?
You may have heard fund managers talk about how they diversify the assets they manage for their clients reeling out reasons why they choose a particular company’s stock. There is this belief that it takes up to 30 assets to have an efficiently diversified portfolio. How true is this? What does it really mean to diversify your investments and how do you do it?
If you’ve come across the paper by Fischer and Loire on Some Studies of Variability of Returns on Investments In Common Stocks” you’d understand why diversification of your investment could be a big deal, but the question is how many assets should you diversify with?
In the coin market for instance, there is no doubt that the value of most digital currencies appreciate or depreciate in tandem with Bitcoin. This actually means that you’re actually not diversified if you’re invested in just BTC and altcoins.
The Fisher and Loire research earlier referred to stated that if your funds are in 30 different assets that the effect is returns scattering reduction. In other words, your losses are minimized while your gains are maximized.
Investment managers give investors the impression that this is what they actually do: pick some 30 well-performing assets and at the end of the day, make everyone happy. However, what is obvious is that there are some proven modalities by which they do this. No serious investor or fund manager would randomly pick assets just to diversify a portfolio.
Risk Reduction Versus Diversification
What we can notice is that investing in 30 assets as the Fischer-Loire study seemed to propose actually results in reduction of risks, not diversification. According to an Investopedia research,
The Fisher and Loire study was primarily focusing on the ‘reduction of risk’ by measuring standard deviation. The study was not actually about any improvements in diversification. A more recent study by Sur & Price addressed the short comings of the Fisher and Loire study by using proper diversification measurements. Specifically, they looked to r-squared which measures diversification as the percent of variance which can be attributed to the market as well as tracking error which measures the variance of portfolio returns versus its benchmark. The results of their study, Table 1, clearly shows that a portfolio of even 60 stocks captures only 0.86 or 86% of the diversification of the market in question.”
In essence, you cannot say that your portfolio is diversified even if you own 60 altcoins or 100. Diversification entails a broader spread of investments which should cover several instruments and subcategories. We shall look at these in a moment. If you’re an investor in the US market, having 60 stocks of big companies diversifies your assets with respect to big companies in the country, but with reference to the world market, you are still not diversified. It is just as if you’re holding Bitcoin and 59 other altcoins. You cannot realistically be said to be diversified while your investment is in a particular market. In these cases, the US capital market and the coin market respectively.
We are aware that the price of Bitcoin rose to $20,000 in 2017 but is presently valued at about half that price in September 2020. The holders (hodlers) of cryptocurrencies could not have missed the need for diversification into other asset classes, with the vicissitude of the coin market.
Hedging Risks Versus Missing A Goldmine
Spreading your risk through investing in more assets is a good idea, but missing out on assets that could make a real difference to your future worth is a big deal. An Investor Solution analysis showed the performance of different classes of investments in the global capital market. What was observed is that being able to identify and invest in companies that are potentially a top performer could make all the difference in diversification.
How would you know in 2011 that Bitcoin would be valued $10,000 today? How would you know that companies like Tesla (TSLA), DELL (Nasdaq: DELL) and Microsoft (Nasdaq MSFT) would be valuable at their early stages? This is the opportunity cost even while reducing risks through diversification.
40% of companies listed in the US lose money. In the coin market, we are aware that many early projects are worthless. Many others were exit scams, so unless the investor conducted due diligence, knowing a token that would be worthwhile is a tough call. Recently, DeFi has proven to be another goldmine but there still are risks, especially with the attention of the Securities and Exchange Commission likely to be called on the possibility that some of the projects might be offering unregistered securities. We saw this with ICOs, it is very plausible with decentralized finance (DeFi).
Based on the performance of global market, Investment Solutions concluded that a diversified portfolio must contain assets comprising stocks of a wide range of local and foreign companies. This means
- Stocks from local and foreign firms. Some of these firms must have small growth while some should have rapid growth.
- Stock from companies from emerging markets.
- Stocks representing various industries such as telecom, health, services, information technology, materials, financials, etc.
- We must not fail to add that emerging assets such as cryptocurrencies and now important investment instruments that must be considered in investment assets diversification.
What Must Be Done
The Coin market is unpredictable and volatile, so it is barely an area where all investments should be channeled. The capital market has stocks that will always be winners. According to Crittenden and Wilcox, 25% of all stocks are the most profitable in the market. We can extend this to other investment instruments.
In conclusion, it is right to say that your focus in portfolio diversification, whether in the stock market or capital market should be finding those 25% that makes the difference in how much wealth you accumulate down the line. Doing this where some of the most experienced market watchers trade some of these assets. You can use the copy trading option to follow them and get the same result.