A Beginner's Guide to Diversifying Your Crypto Portfolio

Investing is a double-edged sword: use it well and it will lead you to prosperity, mishandle it and you may find yourself belly-up. There are different types of tools to help investors get access to well-diversified crypto portfolios.

Intro

Investing is a double-edged sword: use it well and it will lead you to prosperity, mishandle it and you may find yourself belly-up. It is important to keep this in mind when deciding whether to go it alone or enlist help. What you don't know might break you. What you don't know you don't know is sure to land you in ruins.

There are universal concepts (i.e., diversification, rebalancing, dollar-cost averaging, Modern Portfolio Theory) that you certainly know. But do you have the tools to implement them? Can you calculate the diversification ratio of your portfolio?

There are different types of tools to help investors get access to well-diversified crypto portfolios.

One example would be using Macroaxis and a crypto exchange with a large selection of tokens. Armed with those two tools, one could manually decide which of the 6000 cryptos to include in their portfolio and daily run hundreds of portfolio simulations manually to find the desired sweet spot; and then execute those trades on the exchange. The data analytics platform - Macroaxis - costs around US$ 240 a year. It's a bargain for the amount of calculation they enable you to do.

Another example would be using OSOM's Crypto Autopilot.

The team at OSOM curates a universe of investable crypto based on the type and quality of the projects as well as technical indicators such as market capitalization and liquidity. As of May 13, 2021, they were manually tracking 218 Crypto assets for quality, found 102 projects to be worthy and 63 of those to be investable.

The algorithm then looks at the price data of those 63 currencies over the past semester, compares their movements alone and relative to each other, and suggests the ideal crypto portfolio for the next 2.5 to 5 years every 15 minutes. This is then passed through API to the exchange for execution.

The OSOM Crypto Autopilot is built to invest in the well-diversified crypto portfolio created by the algorithm. The algorithm's objective is to minimize drawdowns (when your portfolio loses value) by looking for assets with little downward volatility & maximizing diversification by not investing in assets whose prices move the same way.

It does this with a transparent fee of 10% compared to the performance of Bitcoin over 30 days. So if you don't earn, you don't pay. Undoubtedly, the OSOM Crypto Autopilot is the fastest and most rewarding way to get started if you are a beginner.

But while the OSOM Crypto Autopilot works for you, let's explore what is a crypto portfolio, what you would need to know to build one yourself, from understanding risks, picking assets, and viewing it all in a cryptocurrency portfolio manager.

The structure is as follows:

  1. The universal: Start by Understanding Risks and the risk profile of Crypto as an asset class
  2. Understand how to Diversify within that Asset Class
    1. Understanding the different types of Crypto assets
    2. Picking the assets categories
    3. Picking the assets
      1. By popularity
      2. With research
      3. Mixing, and cheating a bit
      4. How often will you pick?
  3. Tracking your Crypto portfolio

The universal: Start by Understanding Risks and the risk profile of Crypto as an asset class

"Risk" is the likelihood that your investment might be worth less at a theoretical "exit" time than what you invested, or where you need it to be at that point to meet your goals.

If you want to get fancy, you can complexify it a little and say that risk is the likelihood that your investment would be worth less than you invested plus what you did not earn by investing in something that didn't lose money (the "opportunity cost").

The risk that your investment is worth less in the future may be due to different causes. We call those the different "types of risks". The types of risks are different for each asset.

Some to be considered for Crypto might be:

  • Market: the risk that the price is down when you want to exit. And because Cryptos are volatile, it's more of a risk than in other assets.
  • Regulatory: Governments could ban or make Crypto harder to use, which would have a negative impact on the price
  • Technological: the blockchain could be hacked
  • Counterparty: the custodian you are holding your crypto with goes bankrupt and can't return you your money, or you lost access to your own private wallet.

Different types of assets have different risks associated with them. Crypto and smart contracts are exposed to a type and degree of Tech risk that Equities are not. Equities offer a different risk profile than bonds because creditors get paid first in the event of bankruptcy while shareholders usually get nothing.

Understanding the types of risks associated with an asset will help you understand how it fits into your overall portfolio, and how diversified you are in terms of risks.

Some of the risks also lie with you. Can you trust yourself not to sell when the market is down 90%? It's a common occurrence in crypto, and if you cannot stomach it, it might be wise to make sure it's a small part of your overall wealth.

On top of the risks listed above which you will need to consider for each asset, here are some questions which will help you figure out the right mix of "types of risks" to take on:

QuestionWhy ask that Question
How long are you planning to invest?What is risky (the chance you would lose money) over the short term might not be as risky over the long term. Assets might be very volatile daily but always go up in the long term. Find more insights here and there.
How stressful is it for you to see your portfolio lose 30% in a day (even if you are planning on investing that money for 30 years)?As explained in the portfolio construction methodology (p 16) we use, most people underperform the stock market, not because of any objective reasons but because they are scared. If your portfolio is making you make mistakes because you can't sleep at night, you need a different portfolio.
What is the amount of money you need at the end of your investment period, and how much can you invest?The risk for you, here, is not to reach that goal.

How much you invest vs how much you need at the end will tell you how aggressive (ie, taking on risk) you need to be with your investment.

If you find that you can't "stomach" the risk level required, you need to invest more capital or adapt your goals.

How much "complete loss" can you afford?Whether one of your providers goes bankrupt and you can't get the money back, or one of your investment picks goes to 0.

Deciding how much of that you can stomach and how likely it is will tell you the maximum you can put in one asset and in one "custodian".

For example:

  • Bank accounts are insured up to € 100K, so you can feel confident to put up to € 100K there.
  • But Bitcoin's future is uncertain and if you can not afford to lose more than 2% of your overall pension portfolio completely, then put no more than 2% in Bitcoin.

Now that you understand what "risk" is, what the risks in crypto are specifically, and how to go about thinking about it, you are going to need to decide what asset classes you invest in, in what proportion, and for what timeframe. For the overall aspect, we talk about building goal-based strategies & portfolios in more detail here. For building the crypto part of your overall portfolio, here are the steps you can take.

Understand how to Diversify within that Asset Class

You are now ready to build a diversified portfolio of crypto assets, which will fit in your overall investment strategy:

  • You have decided how much money to put into that asset class,
  • how long it was going to stay there for
  • and that you wouldn't touch it in the middle even if it looked like you were going to lose it all at some point.

You need to understand that "crypto" is a vague term. Like "real estate" includes both apartments in New York and Senior Homes in Thailand, there are quite a lot of different things in "Crypto".

Understanding the different types of Crypto assets

There are different types of crypto assets that you can put in your crypto portfolio, just like there are different types of stocks that can go in a stock portfolio. The main categories for crypto are the following:

  • Store of value: Those are the coins like Bitcoin, Litecoin, Nano. They have no intrinsic value or utility but people buy them like they buy gold or diamonds, because they want to park money into something in case something happens. Bitcoin and Nano undoubtedly have advantages over gold and diamonds when it comes to logistics, but they intrinsically have about the same useful value.
  • Infrastructure: like Ethereum, Luna, Solana. Those have a utility in the sense that you need to spend ETH to use the Ethereum blockchain. And if a lot of people want to use that network, it would make sense for the value of that access token to increase in value. Investing in ETH, SOL, LUNA or BSC means you believe the price will go up because more people want to use that platform and there are only so many that token to go around.
  • Centralized or Decentralized Crypto Apps: like PLBT, UNI, COMP, BNT. Those are blockchain "tokens" of companies or Decentralized Autonomous Organisations (DAOs) that are issued on the blockchain. Those companies might or might not do something with the blockchain, but they usually do. Those tokens are usually issued on an "infrastructure" blockchain (ETH, LUNA, BSC,...) because that's what the Crypto App runs on. Sometimes a Crypto App token will also be an "infrastructure" token if an app released its own blockchain with a very narrow use case. The nature of those tokens can vary widely: They can be used for governance, or allow you to receive fees paid by the users of the app to the app, or receive part of future profits,... You have to read the documentation of each app to find out.

And since there are different types, each of those has different risk profiles:

  • Bitcoin, like gold, is useless and tied to how we collectively ascribe its value (market risk). It could also be regulated out of existence (regulatory risk), suffer from a 51% attack that would break the reliability (tech risk), your wallet could be hacked (loss risk) or your custodian could get hacked (counterparty risk).
  • Ethereum, like a utility company, could find itself useless if something with better utility comes along (market risk). Being a utility, it has less of a regulatory risk than Bitcoin, but it's still a possibility. The tech risk is also present, so are the loss and counterparty risks.
  • Centralized or Decentralised apps are like businesses and each token needs to be vetted individually to understand what they offer (strong reputation and barrier to entry, strong tech security, Governance rights or not, fee distribution or not,...). The risks listed for Bitcoin and Ethereum are valid for most crypto apps too. One could even argue that it's more the case since the "base layers" tend to be more vetted and robust than the apps built on top of them.

Picking the assets categories

If you have made it this far you understand the risks you can take, how much money you'll put in the "crypto" asset class, and it is time to pick the asset types you are going to invest in.

Here is one way to think about it:

  • 80% in Infrastructure Tokens
  • 10% Store of value
  • 10% to Apps

This type of portfolio would make sense if you had the following investment thesis:

  • You think this new "crypto" infrastructure is going to replace the current internet infrastructure and that it will be just as revolutionary. You want to own as many contenders as possible to be sure you own the TCP/IP protocol of the future. The good thing is that, whatever the "killer app" ends up being, you won't care because you own the underlying infrastructure anyways.
  • Regarding the "store of value", since it's about as (ir)rational as owning gold, and most experts recommend a 5-10% allocation to gold, so that's a rational choice.
  • Some of those apps are really cool and doing really well, they might be the next Google or Facebook in their field. It has been historically profitable to own the best performing tech companies, so picking some is smart. However, it's super hard to pick winners, so we can limit the exposure to a small part of the portfolio and, when possible, buy an index of them.

Picking the assets

You know your risks, you know your categories. Now you need to research each asset to decide what to invest in. There are two ways of going about it: popularity or research.

By popularity

Not a very smart play, but you could take the most popular coins in each category. A bit like in "index" investing, you take the top 2, 3 or 10 most popular coins.

Today, with the top 2, it would look like this:

  • Store of Value: BTC and XRP
  • Infrastructure : ETH and BNB
  • Crypto Apps: UNI and THETA

But you could easily build the top 10 because cryptos are fractionnable so you can buy 1/200th of a Bitcoin and 1/40th of an ETH. So even with small amounts, it's possible to diversify broadly.

That's how most people start.

With research

It's not always the popular kids who end up winning (ask Bill Gates), and you might be able to find little gems further down the list.

One way to do your research could be using an insights platform such as Messari.io where you can easily screen for "infrastructure", "store of value" and "apps". You can then research each project to see if you think they are going somewhere.

Some things to look for when doing your research is:

  • Project Objective: if you don't understand the point, it's probably not worth it.
  • Developer activity: if no one's working on it, it's not going anywhere
  • On-chain activity: how many people are _actually _using it? Ethereum has 100 million active wallets. Some successful projects have 100.000. Projects with 200 are probably just starting or struggling.
  • Technology: has it been hacked? Has it been audited?
  • Financials
    • Market capitalization: it will give you an idea of how popular it is because even when going with research, you don't want to invest in something that absolutely no one is looking at
    • Liquidity: this tells you nothing about the project but gives you an idea of whether you will be able to sell your position if you need to.
    • Volatility: price goes up, price goes down. By how much? Has it recovered from a historical all-time high and all-time low? Can you support the volatility?

Mixing, and cheating a bit

You might not have a ton of time for research, so you could also employ a mixed strategy.

  • Take the top 2 coins for "store of value", as one could argue that it's unlikely that more than a handful will be widely adopted as stores of value.
  • Take the top 3 coins in "infrastructure", and do some research for another 7 in the top 200 coins. Today, past #200 by market capitalization it's rare to find very liquid tokens.
  • For the Apps, buy a DeFi Index (Decentralized Finance) and do some research to find 3 to 5 others, which are not DeFi, in the top 200.
    • Because DeFi is currently the most adopted use case for Crypto Apps on the blockchain
    • And because taking an index will save you some research and ensure you're diversified. At OSOM we don't think investing like an index is the best idea (read why here), but if you want to go it alone and don't have time for research, it's always an option. DeFi Pulse Index is a well know one

Or, if you used Messari, you can also look at their Venture Capitalist screeners and, for example, reproduce Pantera Capital's portfolio.

How often will you pick?

Congrats. You've now spent hours doing your own research and you know more about crypto than you ever did before.

Also, you have chosen what to invest in today, so next on your "to-do" list is: when do you do it again?

Indeed, whether you have chosen to go by popularity, research or a mix, you have made picks that are valid now. But things move fast and you are going to need to revisit those picks. What's popular today might not be tomorrow, and what's working today might not tomorrow.

You have entered into the world investing into high-growth software companies, and you need to manage your portfolio like a VC.

Once a week might be a bit much but twice a year might be a little too slow for such a fast-moving world.

Tracking your Crypto portfolio

You now have bought the assets you wanted and which fit your investment thesis. You also have an idea when to sell. And you are planning on reevaluating your portfolio periodically.

It's doubtful you have it all in the same place (hint: you shouldn't). You'll have some on ETH wallets, some on a BTC wallet, maybe some other crypto in a couple of reputable exchanges.

The next question is naturally: "How do you track your Cryptocurrency Portfolio?"

You can do so in a crypto portfolio tracker, or crypto coin tracker app. These allow you to track the balances of your wallets and exchanges all in one central place. We have one for free in OSOM where you can track the balances of your ETH wallets, BTC wallets and all the reputable exchanges.

There are also some paid options out there which you will easily find with a quick duckduckgo search. Popular options include Blockfolio and delta.app. Or Zerion.io, which is a crypto wallet tracker useful if you are just buying assets on the Ethereum Network.

And you're all set! You're now the proud owner of a diversified crypto portfolio based on your investment thesis and risk appetite, and maybe more importantly you have a plan for going forward. Best of luck out there!