It’s important to diversify your portfolio. And we don’t mean just having diversification within a given investment portfolio; you should have diversity across all of your assets. Depending on your risk preferences and personal objectives, that might mean you have property, angel investing, passive income, crypto… Yup, we said it. Cryptocurrency.
There’s no getting around the fact that crypto is becoming an increasingly popular security. Some cryptocurrencies, such as bitcoin, are becoming more structured and more popular.
Although we currently don’t offer exposure to cryptocurrency in any of our portfolios, we aren’t going to tell you that you shouldn’t have cryptocurrency in your name… or, in this case, should we say, in your wallet.
Bitcoin is the most usable and widely accepted cryptocurrency, but its primary use cases are still uncertain. We aren’t suggesting you should definitely buy bitcoin, but if you decide you want it, here are a few things we suggest you do to manage it in your personal portfolio:
When an asset doesn’t have a history of being a reliable store of value, we have to consider them high-risk. A ‘high-risk’ asset doesn’t inherently mean that it will give you a higher return; rather, it means that the chance of your higher return is at the expense of a higher chance of you losing a larger portion of your investment.
Most cryptocurrencies are utility tokens. This means they aren’t backed by anything. Instead, their value relies primarily on the network effect (i.e. how many users are using it and how active the users are). This core feature makes them inherently volatile. And this volatility is further magnified by the fact that there are thousands of cryptocurrencies out there competing for active usage.
Think of it this way: If you were to invest in an early-stage company that has a great idea but no proven business model, you might still want to invest in it if you believe in it, but you also know that you’re taking a risk that the investment might not bring you any returns, and might even lose you some money. It’s ok to take some risks when you can afford the loss.
Which brings us to our next point...
Whether all of your crypto allocation is bitcoin, or you have other cryptocurrencies as well, your overall crypto allocation shouldn’t exceed 5% of your net worth. This 5% threshold stands if you’re open to taking on more risk. Just as with any investment, you need to check with your own risk preferences and do your own research. If you’re considering buying bitcoin or other cryptocurrencies, If you’re more risk-averse, consider making your target crypto allocation of your net worth no more than, say, 2% or 3%. Now, this is assuming that the remaining 95% to 98% of your assets are well-diversified across other asset classes as well. You should have the rest of your portfolio diversified, too.
What happens if bitcoin’s price skyrockets and you find yourself with 10% of your net worth in bitcoin? Just as you should do with any asset in your overall portfolio, sell off some of the earnings to rebalance your asset allocation by putting that money in other investments to make sure you stick to your target asset allocation across your entire portfolio. The reason you do this is to avoid concentration risk, which is the potential for a given investment to compromise your portfolio’s well-being.
Regardless of whether you invest in bitcoin, you should check all of your assets quarterly or half-yearly to make sure that your portfolio’s target asset allocation hasn’t gone off balance.
Borrowing money to invest, commonly referred to as leverage, is a double-edged sword because while it can magnify returns, it also can magnify losses.
Using bitcoin as an actual example, the cryptocurrency has an annualised volatility of 56.6% as of 17 November 2020. This means, under normal market conditions, one can expect the bitcoin price to move up or down on average by 3% on any given day (= 56.6% / sqrt(365)). Suppose bitcoin goes through 3 consecutive days of losses; in this case, it’s quite reasonable to expect a drawdown of 9% (= 3 * 3%). An investor who uses 10x leverage to buy bitcoin would see 90% of his or her capital wiped out in this 3-day losing streak (= 9% * 10 = 90%).
Diversifying your overall asset allocation is about increasing your opportunity for returns, but also about spreading out your risk. While diversifying your assets can further strengthen your portfolio's defenses, doing so with leverage only weakens your portfolio’s defenses.
Just the way investing each month into the stock market minimises your risk exposure by preventing over-exposure to any single market condition, investing a little bit each month into bitcoin can prevent you from over-exposing your money to the inevitable swings of bitcoin. As of writing, bitcoin saw a low of less than $4,000 USD in March 2020, and also neared its historical high of nearly $19,800 USD. Given that it’s a utility token, it’s impossible to know if the severe drop will keep dropping or if the spike will keep spiking. So don’t pile 5% of your net worth into bitcoin in one single deposit. Instead, dollar-cost average each month.
Given that bitcoin is a volatile security, it's important not to put money into it that you intend to spend anytime soon. In other words, this bitcoin is the one of the last places you want to put your emergency fund or your funds earmarked for downpayment for that flat next year.
Diversifying your assets is important so that you can bring in more returns from more places. It takes the pressure off of one investment. Investing in different assets can be a great way to learn about a new space or industry. As with any investment, do your research to make sure you understand what you’re invested in. And when you understand what you’re invested in, be sure you’re taking the right steps so that you’re investing responsibly.