IIf you’re looking to mix things up with your traditional investment portfolio, cryptocurrency can serve to fill that role. The highly volatile and speculative asset class has provided investors with both stunning returns and devastating losses.
Many cryptocurrencies regularly post losses of 50% or more within months, weeks or even days, making some millionaires and destroying the savings of others.
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While even the most speculative investors probably wouldn’t recommend putting all of your assets into crypto, it can be useful as a diversification tool. In fact, according to the results of a survey from GOBankingRates, over 22% of crypto investors indicate that their primary goal when investing in crypto is diversification.
But is crypto really a viable diversification option? Keep reading to find out.
What is diversification?
Diversification is a way to reduce your portfolio risk by allocating your assets to a variety of investments. To achieve optimal diversification, these investments will have a low correlation between them. The idea is that if you have two different investments that show a positive rate of return but don’t always trade side by side, you will still get the same return over the long term but with less volatility.
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According to the GOBankingRates survey, investors are increasingly turning to crypto as a tool for diversification, even more so than simply making a quick buck. As a new asset class that doesn’t appear to have direct ties to stock or bond markets, this may make sense.
The Correlation of Crypto with the Stock Market
The problem with using crypto as a diversification tool, however, is that it is becoming increasingly correlated with stock market movements. According to Barron’s, Bitcoin’s correlation with the S&P 500 was only 0.01 from 2017 to 2019, making it a great diversification tool. Unfortunately, this complete lack of correlation has all but disappeared. In 2020-2021, this correlation increased to 0.36; and, by March 2022, it had risen to 0.49.
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What does all this mean? Assets with zero correlation have no correlation. A correlation between 0.30 and 0.49 indicates a moderate correlation, while a figure of 0.50 or more indicates a strong correlation. In other words, Bitcoin is currently a hair’s breadth away from showing a strong correlation with the stock market, meaning its value as a diversification tool is more limited than before.
What cryptos should I consider?
When it comes to using crypto as a diversification tool, experts generally suggest sticking to the two “big dogs” of the space, Bitcoin and Ethereum. There are literally thousands of cryptos to choose from; but, generally speaking, the smaller they are, the more speculative they become.
While Bitcoin and Ethereum fall far short of Treasuries on the risk scale, they are proxies for the crypto market as a whole. If you are simply looking for diversified crypto exposure rather than trying to speculate on a big winner, sticking with industry leaders is usually your best bet.
How much is too much when it comes to crypto?
Although suggestions are ubiquitous, most financial advisors and experts in the field recommend a crypto correlation between 1% and 5%, with very few recommending more than 10%. For example, Alex Doll, CFP and chairman of Anfield Wealth Management, recommends that clients invest no more than 10% of their “risky” assets in cryptocurrencies.
Anjali Jariwala, certified financial planner, CPA and founder of FIT Advisors, recommends no more than 3%. Many advisors simply recommend not investing more money in crypto than you can afford to lose.
Is there value in using crypto as a diversification tool?
A growing number of investors are using cryptocurrency as a diversification tool, and the strategy may have some merit. Although correlations are increasing, crypto remains a fundamentally different speculative asset class from the stock market.
The speculative nature of crypto remains a double-edged sword, as it offers both the potential for explosive gains and the risk of huge losses. As such, experts agree that, especially when used as a diversification tool, allocations should generally be limited to single digits.
Methodology: GOBankingRates surveyed 1,037 Americans ages 18 and older across the country between April 8 and April 9, 2022, asking eight questions: (1) Do you invest in cryptocurrency? ; (2) If you’re not investing in crypto, why not? (Select all that relate to it); (3) How long have you been investing in crypto?; (4) What is your primary goal for your crypto investments? ; (5) What percentage of your investments are in crypto? ; (6) In which crypto(s) do you invest? (Select all that relate to it); (7) How much have you profited from crypto (of all time)? ; and (8) What crypto exchange(s) do you use? (Select all that relate to it). GOBankingRates used PureSpectrum’s survey platform to conduct the survey.
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This article originally appeared on GOBankingRates.com: Best Strategy for Using Crypto to Diversify Your Portfolio
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