Should You Diversify Your Crypto-Assets?

Diversifying any investment assets sounds like a likely success in the long term, but what are the risks when it comes to cryptocurrencies? Levi Meade, Investment Analyst at Columbus Capital, provides some insight for Finance Monthly. Diversification and its benefits is an area that has been covered many times in prominent financial literature and is something that […]

Diversifying any investment assets sounds like a likely success in the long term, but what are the risks when it comes to cryptocurrencies? Levi Meade, Investment Analyst at Columbus Capital, provides some insight for Finance Monthly.

Diversification and its benefits is an area that has been covered many times in prominent financial literature and is something that is both well understood and commonly practiced amongst the traditional investment committee. Therefore I will not seek to reiterate the theoretical advantages of a diversified investment strategy.

However, investing into crypto-assets, as an asset class up till now purely based on speculative value of experimental technology, is a discipline that can prove to be extremely dangerous over the long term without diversification; diversification as a risk reduction strategy is imperative when risk is so high that success of an individual asset is improbable.

Experimental Technology

Crypto-assets are early stage start-ups offering a product completely as open-source software utilising techniques, security models and incentive structures that are largely unproven and at best no more than ten years on the market. This provides two major sources of risk.

Firstly, start-ups mostly fail due to a number of reasons. In general at such an early stage there are an enormous amount of barriers that a founding team need to get past in order to remain in business which are usually disproportionately harder to overcome than problems at later stages of a businesses life cycle. For instance, gaining traction amongst a large enough customer base for survival, in a situation where customers may be reasonably satisfied with existing solutions, can be difficult when human nature tends to be resistant to change. A start-up has to contend with this friction, which is embedded into human behaviour with a significantly superior solution.

Secondly, crypto-assets are pieces of open-source software that harness a variety of concepts from different disciplines which at their intersection requires highly trained experts to build and understand the technology. This creates a much larger probability of there being unknown unknowns regarding the inherent risks of a piece of a technology and on its limitations.

Risk to Reward of a Diversified Crypto Strategy

How does creating a diversified portfolio across the asset class as opposed to a more concentrated portfolio affect the overall risk reward? What is of particular importance is that with such high risk investments come the potential for massively outsized returns. For example, since its inception on the market, Bitcoin has returned over 100,000%. When creating a diversified crypto portfolio, like a venture capitalist, the aim of the game is to increase the likelihood that you are exposed to such outsized gains experienced by the winners. Even in a landscape where the majority of assets experience unfavourable returns over the long term and perhaps go to zero, the outsized gains experienced by a good investment can still lead to above average investment returns.

Also, with regards to the technical risk and the ability for us as investors to assess this technical risk, diversification works as a financial engineering tool to mitigate the affects of unknown unknowns, which may be specific to individual assets. By taking smaller positions in a greater amount of assets you can limit your exposure to such technical risks, which may be difficult to identify or predict.

Why Diversification in Crypto Could Fail

Diversification however does not help to protect against technical risks that affect the entire asset class. Another aspect of investing into experimental technology are the potential risks regarding the foundation of the new technology which could directly affect the entire asset class. One particular risk, which the space is aware of, is the incoming threat of quantum computing. The majority of crypto-assets are secured by some cryptographic problems, which would require an insane amount of computing power to break, which is simply not economically viable given the current technological constraints. However breakthroughs in quantum computing could make it possible to break such cryptographic problems, and in the process rendering Bitcoin and other similar blockchains useless at that point unless they had developed quantum resistance before such an attack occurs. Diversification therefore change the risk profile of the portfolio such that investors are more exposed to broader investment themes or even the some key risks affecting the assets class as a whole in comparison to more asset specific risks.

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