Diversification is a risk management tool that is used to increase the risk vs return profile of a certain portfolio. This is achieved by increasing the number of constituents within a portfolio aimed to reduce the unsystematic risk while at the same time maintaining the expected return profile.
Diversification and its benefits in the traditional market has been covered many times in prominent financial literature and is something that is both well understood and commonly practised amongst the investment community.
Coming to the crypto markets, diversification can be a hard thing to achieve primarily due to some factors which might violate the basic assumptions of modern portfolio theory(MPT) from where the diversification as a risk mitigation measure has been adopted.
MPT was formalised for the economy where investors base their decisions on the expected rate of return of investment and expected ROI can be found out historically after considering the cash-flow and appreciation and common consensus could be formed. In the absence of the cash flow model, while the crypto industry is trying to figure out the valuation model, the industry is a long way from formalising the valuation of assets.
Other key assumptions from MPT which might not hold practically for crypto markets:
1. Crypto markets are still nascent. Hence, may not be efficient and rational attributing to rampant tribalism and ideologies often guiding the investing behaviour
2. Liquidity is low in most of the currencies hence distort the market due to liquidity premiums and slippage
3. Valuation models are not defined hence making fundamental valuation impossible and violating the assumption of base information symmetry among market participants
Furthermore, even if the assumptions of MPT are applicable, correlations in the crypto assets have been high throughout its short history. Hence diversification cannot mitigate the idiosyncratic risk from the portfolio. Especially during the bear market, expanding a portfolio of highly correlated coins does the opposite of diversifying your portfolio because you’re essentially buying BTC+ETH while exposing yourself to risks like illiquidity, price manipulation, hacks, operational overhead, etc.
However, during the last bull market, midcap coins performed reasonably well as the risks were rewarded by huge multiples.
Assuming that one has an absolute belief in the de-centralized future, it might be possible to try and build a diversified portfolio on the longer horizon.
Fat Protocol believers can diversify idiosyncratic risk immediately by balancing protocol investments among platforms.
Similarly, one can hedge market risk by investing in multiple market regimes.
Even though the recent trends are showing decoupling of Bitcoin from the alt universe, the trend is based on a very short period of data and the historical trends indicate that no two assets have been independent over a long period of time, especially during a bear market. I would say that diversification is a myth for crypto in short-medium horizon and all the people saying otherwise are probably just trying to propagate a faulty and out of context premise when the data and facts suggest otherwise.