Crypto Risk Management — Portfolio Diversification Approach
Like in every other form of investment, investing in cryptocurrencies comes with some degree of risk. Poor risk management practices could spell severe consequences for an investor.
In practice, there are two types of risk every investor should be aware of: systematic and unsystematic risk. Systematic risk is as a result of uncontrollable variables which are not asset specific and affects the entire market leading to the fluctuation in prices of all assets. On the other hand, unsystematic risk also known as diversifiable risk refers to the risk that is unique to an asset. These risks emerge out of known variables.
There really is no magic bullet when it comes to investment risks. A solid understanding of risk in its different forms is therefore necessary to help an investor better understand the opportunities, trade-offs, and costs involved with different investment opportunities. Among various risk management strategies, portfolio diversification is one of the favourites among investors and asset managers. A diversified portfolio basically contains a mix of distinct asset types in an attempt to limit exposure to any single asset or risk.
Basics of Portfolio Diversification
Portfolio diversification has many complex iterations but at its core, the logic behind diversification remains the same. Essentially, portfolio diversification is a way for investors to ensure they don’t put all their eggs in one basket. Its purpose is to smooth out unsystematic risks. A portfolio of well-diversified assets still cannot escape all risk, nor can it ensure a profit or guarantee against loss. The portfolio will still be exposed to systematic risk, which refers to the risks that face the market as a whole.
For any given portfolio strategy, there always exists some sort of trade-off between the risk of the investment and the return expected from it. In plain terms, it means the risk and return characteristics would change with the composition of the portfolio.
Typically for a portfolio, the basket of assets chosen all meet certain criteria. For well managed portfolios, the portfolio’s constituents are constantly adjusted so that the portfolio holds only assets that meet its set-up criteria and also to ensure that the assets are held in the proper weights. As assets rise and fall, their weights within the portfolio changes. There exist strategies to handle portfolio rebalancing but that is beyond the scope of this writeup.
Portfolio Diversification in Practice
For new investors, one of the safest options for participating in the crypto market is to diversify their holdings. A uniquely selected basket of equally weighted tokens represents one such option. This strategy is built off the traditional finance model of index investing. Historically, index funds have shown to outperform individual investment vehicles on a risk-adjusted basis over the long term.
A simple iteration of this strategy is investing in a basket of cryptocurrency tokens such as the Amun’s DeFi index token (DFI). Amun’s DFI token represents diversified exposure to blue-chip tokens of the DeFi ecosystem. It is composed of the top eight DeFi tokens in the Ethereum ecosystem by market capitalization.
As an illustration, the sample time frame below shows the performance of DFI against its constituents.
As you can see, the negative performance of 2 assets (SUSHI & COMP) in the basket were compensated by the positive performance of the other 6 assets in the basket.
More about Amun’s DFI token can be found in the Amun’s website and gitbook.
Final Thoughts
Risk is inseparable from return. It is a generally accepted idea that increased risk comes in the form of increased volatility. How much volatility an investor should accept depends entirely on the investor’s tolerance for risk. Also, knowing when to exit an investment is very important. If the basket of assets you have invested in hasn’t performed up to the mark for a long haul or there has been some changes in the underlying structure of the portfolio that doesn’t align with your investment goals or risk appetite, then you might consider exiting the investment.
As a word of advice, always do your own research before committing your funds to any investment. The opinions expressed here are for general informational purposes only and are not intended to provide advice or recommendations for any specific investment product.
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