Cryptocurrency is infamously volatile, presenting lucrative opportunities but also considerable risk.
Last year, Bitcoin outperformed all other traditional assets. Despite the unusually great performance of stocks, bonds, and commodities, BTC investors ended 2019 with a better ROI in the form of a 95% value increase.
Not surprisingly, increasingly investors are including crypto in their wider portfolio. But it doesn’t stop there. Especially because crypto is volatile, it’s important to diversify your crypto portfolio as well.
Let’s explore some approaches.
Why Is it Important to Diversify Your Crypto Funds?
Allocating your investment to various assets that respond to the same event in a different way allows investors to not only limit their risks but also to maximize their Return on Investment (ROI).
Let us present two examples to help you understand this better.
Alice wants to invest in crypto. After researching numerous digital assets, she found an altcoin with a small market cap but a big growth potential. She invests all her funds ($1,000), hoping that it will generate her significant returns in the near future.
However, her luck runs out and the team behind the coin abandons the project. As a direct result of this unfortunate event, holders panic-sell the coin, making the price drop by 50%.
Bob also realized the significant growth potential of the coin Alice had invested in. But he only used a small part of his funds (10%) to gain exposure. Bob uses the remaining (90%) of his funds to buy nine other digital assets that represent different market sectors and use-cases within the crypto space.
While Bob has also been negatively affected by the crash, it only impacted 10% of his funds (-$50), the other nine digital assets in Bob’s crypto portfolio experienced an average value increase of 30% (+$270) in the same period. Therefore, Bob closed his crypto investment positions with a profit of $220, representing an ROI of 22%.
While diversification doesn’t guarantee protection against losses, it’s one of the most important components of a long-term strategy to limit investment-related risks.
Asset diversification is already a popular strategy among general market investors. And it’s a universal technique that you could (and should) also apply to your crypto portfolio.
Risk Factors to Consider Before Investing in a Cryptocurrency
In this section, we’ll explore the most important factors you should consider before investing in a digital asset.
The first indicator you should consider is market capitalization, which represents the current market share of a cryptocurrency. A common agreement within the crypto industry is that the larger the market cap of a coin, the fewer risks it presents to investors.
A digital asset with a large market capitalization could indicate a crypto project that has already built out a decent infrastructure and ecosystem, featuring a significant group of active users that hold, trade, and utilize it for various activities.
The risk of project abandonment is lower for cryptocurrencies with larger market capitalization than for digital assets with a limited share of the crypto market. Also, you can trade these assets more easily.
Furthermore, price swings of large market cap digital assets (like Bitcoin and Ethereum) can influence smaller coins that are related to them (e.g., ETH’s price movements could affect the value of some ERC-20 tokens).
On the flip side, it’s a common occurrence in the crypto space that the larger the market cap a coin has, the less growth potential it possesses.
While this is not true in every case – Bitcoin, for example, had outperformed most digital assets last year –, altcoins (especially the one with small to medium market caps) often outperform BTC during bull markets.
Analyzing the transaction volume of a cryptocurrency provides an insight into the actual use of a digital asset for investors.
This indicator comes in handy when a coin has a decent market capitalization, yet its transaction volume is at very low levels.
You should be very careful with such assets. A low trading and transaction volume could indicate a dead project, no real-world use-case, limited liquidity, as well as a lack of active supporters.
While we’ve seen some crypto startups claim to be disrupting whole industries with revolutionary technology, not all of them were able to fulfill their initial goals.
Therefore, it’s important to analyze the real-world utility of a cryptocurrency from an objective point of view to get an insight into its long-term viability.
Ethereum, for example, is the go-to place for crypto projects to build Decentralized Applications (DApps) and operate smart contracts. And ETH, the native coin of the platform, is utilized in large volumes for everyday transactions by a huge group of active users.
Relevant Market News and Reviews
Researching the potential of a cryptocurrency shouldn’t end with analyzing a project’s whitepaper.
You should also consider checking third-party websites for relevant reviews and user feedback.
Screening crypto (and even mainstream) media outlets for recent news about a project could also help, especially for identifying past, present, and future events that could have an influence on a digital asset’s valuation.
Before making an investment, it’s also important to see which market sector a cryptocurrency belongs to.
We have two reasons to say this.
First, there are industries where crypto projects have proven to be particularly disruptive, with many projects vying to tackle the same issues. This may indicate that this particular sector has a growth potential.
Second, determining the market sector of a cryptocurrency is especially useful when you are allocating your funds into different coins to build a well-diversified crypto portfolio.
It’s a common practice among stock market investors to diversify their funds in a way that the shares they have invested in grant exposure to various industries.
In theory, the correlation of asset prices is higher within the same market sector but lower between two instruments that represent different industries.
The Ultimate Collection of Crypto Market Sectors
While it’s not standard practice in the crypto space, we recommend diversifying your investment across various market sectors within the digital asset industry. This way, you can (further) limit your risks with a chance to maximize your ROI.
Below you can see the collection of the most important market sectors within the digital asset space that you can use to build a diversified crypto portfolio.
Smart Contract Platforms
Examples: Ethereum (ETH), EOS, NEO
Smart contract platforms are the backbone of the blockchain ecosystem.
These decentralized networks allow crypto organizations to build DApps and run smart contracts – computer code that allows a contract to automatically execute itself when conditions are met – on top of their blockchains.
With each smart contract platform featuring its own native digital asset for transactions, these blockchain networks help developers in bringing their ideas to life within a streamlined ecosystem that utilizes a special standard to allow DApp-building in a straightforward way.
Payments and Money Transfers
Examples: Bitcoin (BTC), Ripple (XRP), Stellar (XLM)
Satoshi Nakamoto presented the very first use-case of cryptocurrency when he created Bitcoin in 2009.
As per the original whitepaper, BTC is designed to function as a peer-to-peer electronic payment system that enables users to transfer funds via a blockchain-powered network, potentially offering an alternative to the traditional banking world.
By featuring a network with low-costs, fast transactions as well as continuous operation and high transparency, many crypto projects are aiming to disrupt conventional payment networks.
For example, Ripple (XRP) and Stellar (XLM) have identified the use-cases of cryptocurrencies for cross-border transactions and are operating blockchain networks to offer near-instant and cost-efficient borderless transfers for their clients.
Examples: Monero (XMR), DASH, Zcash (ZEC)
One of the reasons Bitcoin became popular had to do with the additional privacy it offers in comparison to bank transfers.
However, Bitcoin was never designed to function as a privacy coin. As a result – with the use of the latest technology – it is now possible to trace back most BTC transactions and identify parties involved.
Therefore, as there is a real demand for anonymity within the crypto space, projects like Monero, DASH, and Zcash have appeared on the market.
The underlying technology of privacy coins allows users to transfer funds in a pseudonymous way, carving out a significant market sector within the cryptocurrency space.
Examples: Tether (USDT), TrueUSD (TUSD), DAI, Tether Gold (XAUT)
Critics often argue that cryptocurrencies are highly volatile, which may discourage businesses from adopting the technology.
This led to the birth of stablecoins: cryptocurrencies that are pegged to the value of a stable, usually highly liquid asset.
With value-pegs to fiat currencies (e.g., USD, EUR), general market assets (e.g., gold, silver), and other cryptocurrencies, stablecoins allow users to harness the capabilities of digital currencies while limiting the impacts of price swings.
Furthermore, tokenizing general market assets like gold and illiquid shares creates a new set of use-cases for cryptocurrencies.
Examples: Binance Coin (BNB), FTX Token (FTT), KuCoin Shares (KCS) – soon: AAX Token (AAB)
Since Bitcoin’s birth, cryptocurrency exchanges have been functioning as gateways between the digital asset and the fiat world.
Now, quite a few crypto exchanges have created their own native tokens to power their platforms with additional functionality.
While exchange tokens incentivize market makers to provide increased liquidity to the platform, the native coins often also offer discounts to users and to power new features.
As a side note, AAX will soon be launching its own exchange token as well.
Among other functions, AAX Token (AAB) will offer its users trading fee discount (up to 50%), lending and borrowing benefits, as well as access to special features (such as trading bots and signals).
Examples: CIVIC (CVC), Project PAI (PAI)
As a result of numerous high-profile data breaches, people increasingly realize how valuable their personal information is.
While recent regulations (e.g., GDPR), have introduced new measures that force organizations to handle personal information more carefully, there are still issues with the centralized storage of sensitive user data.
Decentralized digital identity applications aim to harness the powerful features of blockchain technology to address these concerns.
While digital identity platforms provide users with more control over their personal data and help them verify their accounts more conveniently, blockchain solutions enable service providers to combat identity fraud in a more efficient way.
Examples: STEEM, Status Network Token (SNT), ReddCoin (RDD)
Tech giants like Facebook, Twitter, and Google dominate the social media space, but crypto projects have introduced a new generation of blockchain-powered social platforms.
Social crypto platforms address the issues of conventional social media networks, such as the lack of privacy and incentives to generate helpful user content.
Steemit, for example, is a social blogging platform where users can receive cryptocurrency as a reward for publishing and sharing unique, helpful content.
Other examples include ReddCoin that offers similar incentives to users in the form of tipping, and Status, a social network that features a private instant messaging application where people can send digital assets to each other.
Examples: Basic Attention Token (BAT), DAD, Carry (CRE)
Cryptocurrency solutions have also appeared in the digital advertising market.
Like most digital asset applications, blockchain advertising-focused networks are aiming to provide alternative solutions to the issues of traditional services.
From a consumer’s perspective, digital advertising is becoming increasingly aggressive and intrusive.
Unless you pay for a subscription or use an ad block service, it’s hard to read a news article, watch a video, or listen to music without getting being bombarded by advertisements. With that said, users are not rewarded for their massive exposure to digital ads.
Projects like Basic Attention Token – that features its own browser (Brave) – aim to introduce new standards to the digital advertising market by incentivizing users to view ads via cryptocurrency rewards.
Data Storage, IoT, and AI Solutions
Examples: STORJ, IOTA (MIOTA), Cortex (CTXC), DxChain Token (DX)
There has been growing interest surrounding innovative industries, such as Internet of Things (IoT), Artificial Intelligence (AI), and modern data solutions.
There are multiple crypto projects building their solutions to interconnect IoT, AI, machine learning.
Examples: Enjin Coin (ENJ), Decentraland (MANA)
In recent years, blockchain gaming has become the next big thing, with popular publishers such as Ubisoft, Epic Games, Microsoft and Sony, piloting the use-cases of DLT technology for their products and services.
And it’s no wonder as blockchain technology can provide significant benefits to the gaming industry.
Take CryptoKitties as an example. This cat-themed blockchain collectibles game became so popular at one point that it congested Ethereum’s network in late 2017.
Blockchain games like CryptoKitties provide true ownership, probably fair gameplay, and an opportunity to earn coins (play-to-earn vs. pay-to-earn) in-game.
Borrowing, Lending, and Other DeFi Solutions
Examples: SALT, NEXO, WAVES
Decentralized Finance (DeFi) is a relatively new concept.
And it has created a whole industry for itself by offering blockchain- and crypto-powered finance applications that serve as decentralized alternatives to popular solutions on the traditional finance market.
Lending and borrowing are one of the most widespread use-cases of DeFi DApps that allow users to borrow funds using their crypto as collateral or to earn interest on their coins by lending their digital assets to others on the platform.
Examples: Solve Care (SOLVE), Doc.com Token (MTC), Dentacoin (DCN)
While the healthcare industry is one of the top priorities for both governments and citizens, it is facing a multitude of issues.
As a possible solution to (a part of) the industry’s issues, blockchain applications have appeared on the healthcare market, piloting how DLT could benefit the sector.
For example, the crypto startup Doc.com has created an application that leverages the combination of AI and blockchain technology to provide medical assistance to users.
On the other hand, Dentacoin is more focused on prevention, while Solve Care has created a whole blockchain-powered healthcare ecosystem for medical service providers and enterprises.
Market Sectors: The New Way to Diversify Your Cryptocurrency Investment
When you decide to invest in an asset, it’s crucial to keep your risks to a minimum to limit your losses and maximize your potential gains.
To do that for your crypto portfolio – before investing –, consider analyzing digital assets utilizing factors, such as market capitalization, transaction volume, utility, market sector, as well as relevant user feedback and news about a project to support your financial decision.
While it’s not a new concept, allocating your funds to cryptocurrencies that together represent a wide range of market sectors is a decent way to (further) limit your risks and increase your potential ROI.
We’ve discussed the fundamentals of digital asset investments in this article. In the second part of the series, we’ll dive into the practical details of building a well-diversified crypto portfolio.