Cryptocurrencies in Long-Term Diversification - dummies

Cryptocurrencies in Long-Term Diversification

By Kiana Danial

When it comes to adding cryptocurrencies to your portfolio, keep the following two types of long-term diversification in mind:

  • Diversifying with non-cryptocurrencies
  • Diversifying among cryptocurrencies

For more information on many of these topics, check out these Invest Diva resources:

Diversifying with non-cryptocurrencies

You have so many financial instruments to choose from when you consider diversifying your portfolio across the board. Stocks, forex, precious metals, and bonds are just a few examples. Each of these assets has its unique traits. Some assets’ inherited risks can offset the risks of the other ones through long-term market ups and downs. The following sections provide guidance on how to use cryptos and non-cryptos together in the long term.

No single golden diversification rule works for all investors. Diversification percentages and the overall mix greatly depend on the individual investor and his or her unique risk tolerance, as I talk about on my website.

The more risk you’re willing to take, the higher the chances of a bigger return on investment, and vice versa. If you’re just starting out and have a lower risk tolerance, you may consider allocating a bigger portion of your portfolio to bonds and then systematically adding stocks, precious metals, and cryptocurrencies.

Background on trading fiat currencies

Fiat currencies are the traditional money that different countries’ authorities declare legal. For example, the U.S. dollar is the official currency of the United States. The euro is the official currency of the European Union and its territories. The Japanese yen is backed by Japan. You get the idea.

The foreign exchange market, or forex, is a huge market where traders trade these fiat currencies against one another. Having a bit of a background in forex can help you better understand the cryptocurrency market and how you can trade the different types of currencies against one another. I compare this market to a big international party where all the couples are made up of partners from different regions. So if one is the Japanese yen (JPY), her partner may be the euro (EUR). I call them Ms. Japan and Mr. Euro. If one is the U.S. dollar (Ms. USA), her partner can be British, Portuguese, or Japanese.

In the forex market, these international pairs get together and start “dancing.” But oftentimes, the paired-up partners aren’t compatible, and their moves aren’t correlated. For example, every time Ms. USA makes a good move, her partner screws up. Every time her partner picks up the rhythm, she’s stuck in her previous move. These incompatibilities gain some attention, and a bunch of people who are watching the dancers start betting on which of the partners is going to screw up next. Those folks are the forex traders. You can watch this forex metaphor in action in my video.

The point is that when trading currencies — fiat or crypto — you can only trade them in pairs. For example, you can trade the U.S. dollar (USD) versus the Japanese yen (JPY); this is the USD/JPY pair. You can trade the Australian dollar (AUD) versus the Canadian dollar (CAD); that’s the AUD/CAD pair.

Quote currency versus base currency

When trading currency pairs, the base currency is listed first, and the quote currency is listed second. Which currency in a given pair is the base currency and which is the quote currency is normally fixed across the trading markets. For example, when talking about trading the U.S. dollar versus the Japanese yen, the currency of the United States always comes first, followed by the currency of Japan (USD/JPY). In the EUR/USD pair, the euro always comes first, followed by the U.S. dollar.

These set patterns have nothing to do with whether a certain currency’s country is more important or whether one currency in a pair is more popular than the other. It’s just how the trading crowd set things up. The system doesn’t change, which means everyone is on the same page and navigating through the pairs is easier.

As the base and quote come together, the currency pair shows how much of the quote currency is needed to purchase one unit of the base currency. For example, when USD/JPY is trading at 100, that means 1 U.S. dollar is valued at 100 Japanese yen. In other words, you need 100 Japanese yen (the quote currency) to buy 1 U.S. dollar (the base currency).

The same concept applies to cryptocurrency pairs. Many cryptocurrency exchanges offer a select number of quote currencies, mainly popular ones such as a fiat like the USD and cryptos such as Bitcoin, Ethereum, and their own exchange cryptos. Then they offer trading opportunities versus all the hundreds of other cryptocurrencies they may carry versus these quote currencies.

Trading cryptos versus fiat currencies

Similar to the forex market, you can trade cryptocurrencies versus other currencies. The most common approach at the time of writing is trading them versus a fiat currency, typically the one backed by the country you live in. For example, in the United States, most people trade Bitcoin versus the USD. They don’t really think of it of trading these currencies in pairs because it feels a lot like buying a stock. But the fact is that when you buy Bitcoin using the U.S. dollar in hopes of capital gain, you’re essentially betting that the value of Bitcoin will move higher against the U.S. dollar in the future. That’s why if the U.S. dollar decreases in value (not only against Bitcoin but also against other currencies) at the same time that Bitcoin increases in value, you’re likely to make more return on your investment.

This is where diversification can help you reduce your trading risk. As I explain in the later section “Diversifying among cryptocurrencies,” most cryptos are correlated to Bitcoin in shorter time frames. That’s why you can diversify your portfolio with the fiat currencies you trade them against. For example, if you think that at the time you’re trading, the U.S. dollar and the Japanese yen aren’t correlated, you can open up two Bitcoin trades: one versus the U.S. dollar and one versus the Japanese yen. Of course, in order to do so, you should make sure your exchange or broker carries these different fiat currencies and offers such trading opportunities.

Speculating the markets and short-term trading carry a lot of risk. It may not be suitable for all investors, and you may end up losing all your investment. Before deciding to trade such assets, you should carefully consider your investment objectives, level of experience, risk tolerance, and risk appetite. Also, you should not invest money that you can’t afford to lose.

Diversifying among cryptocurrencies

The majority of cryptocurrency exchanges offer a wider selection of cross-crypto pairs than they do fiat/crypto pairs. In fact, some exchanges don’t even accept any type of fiat currencies altogether. That’s why many traders have no choice but to trade one cryptocurrency against another. Bitcoin (BTC) versus Ethereum (ETH) gives you the BTC/ETH pair, for example.

As you can imagine, the thousands of different cryptocurrencies available to trade mean the mixes and matches can be endless. Many cryptocurrency exchanges have categorized these mixes by creating different “rooms” where you can trade the majority of the cryptos they carry versus a number of more popular cryptos. For example, as you can see in this figure, the Binance exchange has created four rooms or categories for the main cross-cryptos: Bitcoin (BTC), Ethereum (ETH), Binance Coin (BNB), and Tether (USDT). By clicking on each of these categories, you can trade other cryptos versus the selected quote currency.

cryptocurrency binance exchange
Source: Binance.com

Binance exchange cryptocurrency pairing options.

When trading currency pairs, fiat or crypto, the best bet is always to pair a strong base currency versus a weak quote currency and vice versa. This way, you maximize the chances of that pair moving strongly in the direction you’re aiming for.

The reason you diversify your portfolio is to reduce its exposure to risk by including assets that aren’t fully correlated. The big problem about diversifying within your cryptocurrency portfolio is that, at least at the time of writing, most cryptocurrencies are heavily correlated to Bitcoin. Most of the days where Bitcoin was having a bad day in 2017 and 2018, the majority of other cryptocurrencies were, too. The following figure, for example, shows a snapshot of the top 12 cryptocurrencies on August 18, 2018. All are in red. In fact, 94 out of the top 100 cryptocurrencies by market cap were plummeting that day. (Market cap shows the value of all units of a crypto that are for sale right now.) In the crypto market, this type of short-term market correlation has become the norm.

cryptocurrency correlation BTC drops
Source: CoinMarketCap.com

Correlation between the top 12 cryptocurrencies and Bitcoin as BTC drops.

August 19, the very next day, Bitcoin turned green, and so did the majority of the cryptos in the top 100, as you can see in the figure. In this snapshot of the top 17 cryptocurrencies, all tokens besides Tether (USDT) surged about the same amount Bitcoin did, around 1.72 percent.

cryptocurrency correlation BTC surges
Source: CoinMarketCap.com

Correlation between the top 17 cryptocurrencies and Bitcoin as BTC surges.

On the other hand, if you look at the bigger picture, say the seven-day price change, you notice that the market correlation to Bitcoin is more mixed, as shown . For example, while Bitcoin gained 1.25 percent in the seven days before August 18, Ripple’s XRP gained 8.51 percent, and Dash lost 9.79 percent.

cryptocurrency correlation
Source: CoinMarketCap.com

The top 17 cryptocurrencies are less correlated in the seven-day time frame.

This correlation is one key reason short-term trading cryptocurrencies is riskier than many other financial instruments. Considering long-term investments when adding cryptocurrencies to your portfolio may be best. That way, you can reduce your investment risk by diversifying within different crypto categories.

On the bright side, as the cryptocurrency market continues to develop, the diversification methods can also improve, and the whole market may become less correlated to Bitcoin.