Anything that is worth it in life comes with a fair bit of risk. Risk is almost as certain as taxes. Money and finances are no different. When investing, you need to look for ways to manage your exposure to avoid suffering huge losses to capital.
What is Portfolio Diversification
Portfolio diversification is sometimes referred to as the seatbelt of portfolio investments. It’s that roll-bar across your lap on a rollercoaster that stops you from flying off the ride. Investors diversify their portfolios to reduce risk and “smooth out” the bumps in their investment journey. A broad diversification strategy will generally allow your returns to be more stable and diffuse the overall risk for an investor. This logic is especially important with the current coronavirus pandemic, which has caused many markets to act in a volatile manner.
Time and Correlation
These two phrases are the most essential elements of portfolio diversification. Money invested for short term goals should be invested differently than funds reserved for long term goals. In general, a longer time frame allows you to take more risks with your investments.
The second part of the equation is correlation, which refers to the degree to which your investments move in tandem. If your entire portfolio is geared towards a specific type of stock or cryptocurrency, and hence it all moves in the same direction when certain shocks occur in the market, then your portfolio is not diversified.
The most basic form of allocation between this is stocks and bonds. However, there are various ways to add complexity to a portfolio, such as investing broad, mixing mutual funds and exchange-traded funds (ETF’s), or varying the company size and type you invest in.
Types of Risk
There are two types of risk when it comes to investing. Systematic risk cannot be diversified and must be accepted by investors no matter what industry or stock they choose to invest in. This risk is due to exchange rates, uncertainties, natural calamity, and inflation.
Unsystematic risk is the one that can be reduced by diversifying a portfolio, so when we talk about reducing risk, it is this type of risk we are referring to.
Cryptocurrency and Bitcoin
Moreover, with cryptocurrency generally behaving oppositely to the traditional stock market, adding cryptocurrency like Bitcoin to your portfolio is a clever way of diversifying and spreading the risk.
The Modern Portfolio Theory, which is one of the most widely used models in the financial industry for portfolio diversification, makes two important assumptions:
1. Investors are risk-averse, preferring a portfolio with a higher return for a given level of risk
2. Risk can be reduced through diversification
An example of diversified risk with Bitcoin added to the portfolio showed an increase of 1.3% to portfolio return with no change in volatility risk.
The reason for this higher return lies in the low correlation of Bitcoin compared to other asset classes, which moves the efficiency of the portfolio to a greater level.
Bitcoin also holds several benefits that make it a great asset class for investment. Its underlying technology, the blockchain, provides a secure platform that is undeniably solid, cannot be hacked, and cannot be traced. Secondly, the decentralisation of Bitcoin as a currency is the main reason which allows the coins to be exchanged without any central authority. Centralisation has a lot of issues like complex money transfer processes and intermediary charges, all of which are done away with, with the advent of Bitcoin.
The Bottom Line
When considering whether to add Bitcoin as a means of diversifying your portfolio, the answer is… maybe. It depends on your risk tolerance capacity, the amount of investment, and your present portfolio landscape. If you are looking to add more stability, then Bitcoin may not be for you, although as we have discussed, because of its lack of correlation with other markets, it may help to reduce the overall risk exposure of your portfolio.
To maintain the risk profile of your diversified portfolio, it needs to be rebalanced annually, but most preferably quarterly.
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