This article aims to provide an overview of decentralized finance (DeFi) risks and the steps needed to manage them. If you are unfamiliar with DeFi, do read our introductory article on DeFi before reading this article. You may also consider reading our article on cryptocurrency, DeFi risks, and Dollar Cost Averaging (DCA) before reading this article.
What Is Portfolio Diversification?
“Don’t put all your eggs in one basket” is an adage that has been around for centuries, and it is actually an academically proven strategy to reduce overall portfolio risk. Diversifying a crypto portfolio involves investing money in different crypto projects to reduce risk if any project performs poorly. Spreading investments across different protocols also exposes users to more crypto assets. For example, a crypto portfolio can consist of 40% Bitcoin (BTC), 25% non-fungible tokens (NFTs), 20% stablecoins, and 15% altcoins.
With the unpredictable nature of crypto, diversification helps to protect users against unexpected negative market swings and improve long-term risk-adjusted returns. By owning multiple assets that perform differently, your overall portfolio can profit even if some of the allocated assets within a portfolio perform poorly. Nevertheless, it is still important to regularly check and rebalance asset allocations, given the volatile nature of crypto.
Why Does Diversification Work?
“Risk-adjusted returns” are desired by investors in trading and investing in order to get the most bang for their buck. Risk-adjusted returns refers to the concept of improving the relationship between return and risk in a portfolio in comparison to a common benchmark, such as the entire market capitalization of the crypto market or BTC. In other words, it is how users can obtain a higher return when risks associated with underlying assets are factored in.
Diversification can greatly boost risk-adjusted returns as it limits users’ exposure to any single asset risk. DeFi risk can be divided into two categories: market risk and idiosyncratic risk. Idiosyncratic risk refers to risks that are unique to a specific asset. The key concept here is that by having several assets with varying correlations, users can effectively minimize portfolio total risk.
r = α + rf + β(rm - rf) + ε
The returns model, “r”, for every given asset is represented by the expression above. The error term “ε” represents idiosyncratic risks. Since idiosyncratic risks are heterogeneous in nature, as more assets are added to a portfolio, ε diminishes and tends toward elimination in the long run!
The graph above shows how total risk can be successfully reduced when more assets are added to a portfolio. More assets, however, will not necessarily minimize risk because users will still be subject to market risk, which is the risk exposure that impacts the entire crypto market in general. Keep in mind that as more assets are added to a portfolio, the marginal advantage of diversification decreases, meaning more is not always better. Thus, having over 100 different assets is not only unrealistic for a retail investor, it is also excessive because the additional benefits from diversification decreases while the complexity of managing many assets increases.
How to Diversify Your Portfolio?
1. Crypto With Different Use Cases
Crypto is used as a medium of exchange, but usage is not only limited to transactions in exchange for goods and services. For example, while BTC was created to be a virtual currency, it can also be used as a store of value, or a means to preserve and grow wealth. On the other hand, Ethereum has smart contract functionalities which allow the creation of digital programs. This would be an investment in a blockchain network where decentralized applications can be built. Crypto investors can also allocate a portion of their portfolio to stablecoins, where their consistent value, relative to altcoins, helps to counter the crypto market’s volatility. Other baskets of use cases include Layer-1 and Layer-2 infrastructures, GameFi, DeFi, and many more! Investing through different use cases can help reduce overall idiosyncratic risks since each will have varying risk exposures.
2. Invest in Different Crypto Blockchains
Different crypto projects have different foundations and technologies that sustain them. Crypto investors should select those that correspond with their investment objectives. Spreading investment assets across various chains reduces overall risk, especially if one particular chain happens to crash. One good example would be the crash of the Terra chain. Regardless, it is important to do your own research or DYOR in order to minimize risks. Factors such as crypto prices, past trends, and future potential are integral to the decision-making framework. Learn more about how to make sense of these metrics in DeFi here!
3. Diversify by Market Capitalization (Cap)
The renowned Fama-French Three Factor Model states that small cap assets tend to outperform larger cap assets. Applying this finding to the crypto market shows that cryptocurrencies with larger market caps may be more stable and have stronger fundamentals, but those with smaller market caps might have strong growth potential due to their volatile nature. Currently, BTC has the largest market cap of about US$366B as of October 2022. Although BTC occupies the largest portion of crypto market share, many other altcoins with varying market caps are worth considering for investment, such as Solana, Avalanche, and Polygon.
4. Having Different Asset Classes
While the most common asset class would be coins and tokens that are a store of value or medium of exchange, another asset class investors can consider is utility tokens. These give users the right to derive benefits from holding the utility token, such as having exclusive access to real-world events or parties in the case of a social utility token or playing a part in making governance decisions in the case of governance tokens. Non-Fungible Tokens (NFTs) are another class of assets that are digital representations of ownership and can be considered for investment.
5. Diversify by Risk Level
Assets can be allocated based on risk level depending on an investor’s risk appetite, and one of the most widely utilized metrics is volatility. In traditional finance (TradFi), there is a well-known approach known as the “Low Volatility” strategy, in which investors allocate funds to low-volatility assets. Investors can do the same in crypto by looking for low-volatility strategies or tokens. Stablecoin staking is an example, as the volatility of such a strategy mimics the volatility of the underlying stablecoin, which is theoretically close to zero. On top of diversifying through thematic use cases, which are more qualitative, using volatility can be a more quantitative approach to diversification.
At the end of the day, we believe that keeping your investments well-diversified is one of the golden rules of successful investing. Apart from diversifying within the crypto space, investors can also look toward other asset classes, such as equities, fixed income, and commodities within the TradFi space. By diversifying your portfolio, you will not be exposed to highly concentrated risks that may make or break your investment portfolio.
At Treehouse, we want to empower people to navigate DeFi confidently and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces!
- How to Make Sense of Metrics in DeFi
- The Truth About Audits in DeFi
- DeFi Risks: What You Need to Know
- How to Manage Your DeFi Risks With This Framework
- Introducing Price Risk and Basic Trading Strategies
- Flash Loans and Flash Loan Attacks? What Are They and How to Prevent Them?
- A Look Back at Past Crypto Winters: Then Till Now
- How to Measure Your Price Risk in DeFi
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!
This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.