Crypto Diversification is Pointless

As my bag of cryptocurrencies continues to grow, my morning routine of updating all the prices each day gets longer.  One thing is pretty clear, every morning almost all of my holding tend to be either green or red.  There are, of course, exceptions but about 90% are always the same color.  If this is the case, what is the point of holding all these different coins?

I didn't set out to hold so many different coins and tokens, it just kind of happened organically.  Many of these I've earned for free doing different tasks and represent just a small portion of my portfolio, yet I somehow feel a connection to just about everyone of them.  I also have them all listed on CoinGecko, but I like the process of manually updating the prices each morning as well as the number of coins for those I'm staking and earning interest or gaining in platforms like PublishOX, Read.Cash and Torum.

In going through my morning ritual day-after-day it has become pretty clear, crypto diversification is pointless...

The Federal Bank of Chicago this month released a report titled - How Interconnected Are Cryptocurrencies and What Does This Mean for Risk Measurement?  In it, the author Filippo Ferroni concludes, "I find the cryptocurrency market to be extremely interconnected."  So just how correlated are these coins and what is causing the price volatility in the first place?  Ferroni continues, "I compute using different specifications, sample sizes, and time windows range between 86% and 97% (where 100% indicates maximum connectedness). This means that most of the variations in the prices in the cryptocurrency market are the results of the market’s spillovers and only a small fraction can be ascribed to the idiosyncratic characteristics of individual digital currencies."

Bitcoin very much trades like a technology stock so if you follow the NASDAQ you have a good idea how BTC will move.  It tends to be a multiple of the index which sits around 14,000 today with BTC around 42,000.  You can also guess the price movement of BTC based on its inverse correlation to the dollar so when the dollar falls, BTC goes up and vice-versa.

As for altcoins, they tend to all move in the same direction and the explanation is really quite simple.  When these coins get listed on an exchange, they get connected and paired with Bitcoin or Ethereum.  Bots tend to match these coins or tokens to their paired coined so they tend to stay within a small range in terms of price ratio, especially on the lower grade coins.  If you want to track the whole crypto market look at Bitcoin and Bitcoin Gold, Bitcoin Cash and Litecoin will follow BTC's lead.  If you are looking at most altcoins, however, Ethereum usually leads their price action because many are paired with ETH and they are built on the Ethereum blockchain (ERC-20 coins).

We can see that arbitrage bots are doing most of the trading these days and controlling the price movements of altcoins.  Until a coin gets around $100M in real (not bot) trade volume, it tends to follow its paired coin.  Please also keep in mind that correlations can change and are a measurement of what has happened and cannot predict what will happen in the future with any certainty but this does give us a good idea of what will most likely happen going forward.

So what does all this mean?  Well, your crytpo strategy should take this correlation into account.  When you also factor in that many altcoins may no longer exist down the road, you can develop a long-term strategy that makes sense.  Personally, my crypto portfolio is heavily weighted towards three coins or types of coin - Bitcoin, Ethereum and stablecoins (primarily USDC and BUSD at the moment).  I stake these and earn interest on all three to help maximize long-term growth in addition to price appreciation and diversify somewhat by having them on different exchanges or in different wallets.

The remainder of my crypto assets are in projects like yield farming and master nodes.  I can take profits from these projects and turn them back into any of my three primary coins.  I like these projects as a way to spice things up and force me to continually learn new technologies and techniques in the crypto space.

While I do hold a number of other coins, it is in small amounts and I really don't care as much about their individual price action despite checking them daily out of habit.  Overtime, I will continue to convert these to BTC, ETH or a dollar-pegged stablecoin as well.

If you follow crypto investors on any of the plethora of platforms out there like Twitter, Discord, Telegram or Reddit you will find many married to a particular altcoin they are convinced will "moon".  A very small percentage will, however you chances of picking the right one from the ten thousand plus available are pretty slim.  There is a reason these are called "shitcoins" and you are much more likely to lose on one of these rather than simply holding a top coin with a large market cap that is likely to be around for years.  Their passion for these coin is high, however with passion comes emotion and with emotion comes poor investment choices.

I encourage you to take a step back and consider the facts I've laid out in this article and examine your current mix of coins.  Next, rethink your overall investment strategy based on logic taking what you know into account and taking emotion out of the equation.  I do suggest taking a small set percentage of your portfolio and allocating it to projects or an altcoin or two you happen to really believe in.  You might lose a bit, however, with a relatively small amount this risk capital can provide a good learning platform for you as you increase your overall crypto knowledge base making it a good investment of time if nothing else.  In addition, having a passion for something is fun and can also pay financial dividends - just don't put all your crypto eggs into one speculative basket.

Understanding correlation between investments leads to better overall health of your portfolio and higher long-term gains.  This is not only true of your crypto, but of everything you own including stocks, bonds, real estate and other physical assets.  So what is your strategy to minimize correlation between your coins?