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An educational thread on diversification, "the only free lunch" in investing. Diversification lets you get the same exact expected return, with lower risk. Read to the end for a direct discussion of diversification in cryptocurrency. /1
2/ Adding any asset with <100% correlation to your existing portfolio produces a diversification benefit. People often think of correlation as binary (i.e. is this correlated or uncorrelated), but that's wrong. You get a benefit even at 95% correlation, just a small one.
3/ the holy grail is to find assets with *negative* correlations to your portfolio with positive returns, but those are hard to find. Those assets simultaneously increase return and reduce risk. Usually we have to settle for just a moderate risk reduction from <100% correlation
4/ A big problem is that correlation is calculated using backward looking data, but what we really care about is the future. Uncorrelated assets often become highly correlated in a crisis or drastic sell-off, which is exactly when we care most about correlation.
5/ So while I look at the historical correlation, I place more weight on my own best guess of forward correlations in extreme scenarios that I try to estimate very roughly with economic rationale and market psychology. Admittedly, just guesses.
6/ In cryptocurrency, I think about diversification along a few axes. Idiosyncratic risk, market regimes, and protocol risk.
7/ For example, if you have a portfolio with 50 assets, but they're all ERC20 tokens, you're 100% concentrated along the protocol risk axis. A fundamental bug in ethereum might destroy your whole portfolio.
8/ "idiosyncratic risk" refers to risks that are really unique to a single asset or project. For example, what happens if the team behind the project is all on a bus and that bus gets into a tragic accident? This is the easiest to diversify.
9/ For regime risk, we have to think about how the crypto markets trade and are likely to trade in the future. The largest 'regime risk' is Bitcoin vs altcoins. There are periods where BTC rallies and everything else sells off and vice versa.
10/ With all of this said - it makes no sense to diversify into bad investments. I'd much rather have a portfolio of 3 good assets than one of 3 good assets and 97 bad ones. In cryptocurrency, there are relatively few good assets, and correlations are very high in sharp sell-offs
11/ This means that the benefit to diversification in cryptocurrency is *much* smaller than in the equity or credit world. A highly concentrated portfolio makes sense in most cases.
12/ lastly - I don't think there's much if any diversification benefit to adding other assets to BTC. Why? Because in the event of a dramatic BTC crash, most/all other cryptocurrencies are likely to crash as well. We see this empirically in markets, but it's also true
13/ for a few other reasons. If a critical bug was found in bitcoin code, people will distrust other protocols with newer and less tested code for example. If PoW was found to be fatally flawed, people would become skeptical of even newer, less tested consensus mechanisms.
14/ Of course, other assets may outperform, but they don't reduce the risk of your portfolio via diversification. TDLR: diversification is great and important, but need to think about specifics case by case.
