Cryptocurrencies in Long-Term Diversification

Cryptocurrencies in Long-Term Diversification

When it comes to adding cryptocurrencies to your portfolio, consider the following two types of long-term diversification:
1. Diversify using non-cryptocurrencies
2. Diversify between cryptocurrencies

Diversify using non-cryptocurrencies
You have many financial tools to choose from when you are considering diversifying your portfolio across the board. Stocks, forex, precious metals, and bonds are just a few examples. Each of these assets has its own unique features. Some of the inherent risk of assets can offset the risk of other risks through the long-term rise and fall of the market. The following sections provide guidance on how crypto and non-cryptocurrency can be used together in the long term.
There is no single golden rule of diversification that is valid for all investors. Diversification ratios and overall mix are highly dependent on the individual investor and their unique risk tolerance, as I talk on my website.
The more risk you are willing to take, the higher the chances of making a greater return on your investment, and vice versa. If you are just starting out and have a lower risk tolerance, you might consider dedicating a larger portion of your portfolio to bonds and then systematically adding stocks, precious metals, and cryptocurrencies.

Background on fiat currency trading
Paper currency is the traditional money that the authorities of different countries declare to be legal. For example, the US dollar is the official currency of the United States. The euro is the official currency of the European Union and its dependent territories. The Japanese yen is backed by Japan. You found the idea.
The foreign exchange market, or forex, is a huge market where traders trade these fiat currencies against each other. Having a little background in forex can help you better understand the cryptocurrency market and how you can trade different types of currencies against each other. I compare this market to a big international party where all the couples are made up of partners from different regions. So if one of them is the Japanese Yen (JPY), its partner may be the Euro (EUR). I call them Mrs. Japan and Mr. Euro. If one of them is US Dollars (Ms. USA), her partner can be British, Portuguese or Japanese.
In the forex market, international pairs come together and begin to “dance”. But often, the two partners in pairs do not get along, and their movements are not correlated. For example, every time Mrs. USA makes a good move, her partner fails. Every time her partner picks up the beat, she’s stuck in her previous move. These incompatibilities gain some attention, and a group of people watching the dancers start betting which of the partners will fail next. These people are forex traders. You can watch this forex metaphor in action in my video.
The point is that when you trade currencies – fiat currencies or digital currencies – you can only trade them in pairs. For example, you can trade the US dollar (USD) against the Japanese yen (JPY); This is the USD/JPY pair. You can trade the Australian Dollar (AUD) against the Canadian Dollar (CAD); This is the AUD/CAD pair.
Quote currency vs base currency
When trading currency pairs, the base currency is listed first, and the quote currency is second. The base currency of any particular pair and the quote currency in the trading markets is usually determined. For example, when talking about trading the US dollar against the Japanese yen, the US currency always comes first, followed by the currency of Japan (USD/JPY). In the EUR/USD pair, the euro always comes first, followed by the US dollar.
These specific patterns have nothing to do with whether the country of a particular currency is more important or whether one of the currencies in the pair is more popular than the other. It’s just the way the trading audience set things up. The system does not change, which means that everyone is on the same page and navigating between pairs is easier.
When the base and quote come together, the currency pair shows how much of the quote currency is needed to buy one unit of the base currency. For example, when USD/JPY is trading at 100, it means that one US dollar is valued at 100 Japanese yen. In other words, you need 100 Japanese yen (the quote currency) to buy 1 US dollar (the base currency).
The same concept applies to cryptocurrency pairs. Many cryptocurrency exchanges offer a set number of quote currencies, especially popular currencies such as fiat currencies such as the US dollar and cryptocurrencies such as Bitcoin and Ethereum and their cryptocurrencies. Then they offer opportunities to trade against all the hundreds of other cryptocurrencies they might hold in exchange for those pricing coins.

Trade cryptocurrency for fiat currencies
Similar to the forex market, you can trade cryptocurrencies against other currencies. The most common method at the time of writing is to trade it for fiat currency, usually the backed currency of the country you live in. For example, in the United States, most people trade Bitcoin for the US dollar. They don’t really think about trading these currencies in pairs because it’s a lot like buying a stock. But the truth is that when you buy Bitcoin with the US dollar in the hope of making capital gains, you are basically betting that the value of Bitcoin will rise against the US dollar in the future. That’s why if the value of the US dollar drops (not only against Bitcoin but also against other currencies) at the same time as the value of Bitcoin increases, you will likely make a greater return on your investment.

This is where diversification can help you reduce your trading risk. As I explained in the last section “Crypto Diversification,” most cryptocurrencies are tied to Bitcoin in shorter time frames. That’s why you can diversify your portfolio with the fiat currencies you trade against. For example, if you believe that at the time you are trading, there is no correlation between the US dollar and the Japanese yen, you can open two Bitcoin trades: one against the US dollar and one against the Japanese yen. Of course, in order to do that, you must make sure that the exchange or broker you are dealing with holds these different fiat currencies and offers such trading opportunities.
Speculating in the markets and short-term trading carries a lot of risks. It may not be suitable for all investors, and you may end up losing all of your investment. Before deciding to trade such assets, you should carefully consider your investment objectives, level of experience, risk tolerance, and risk appetite. Also, you should not invest money that you cannot afford to lose.

Diversify between cryptocurrencies
The majority of cryptocurrency exchanges offer a wider selection of cryptocurrency pairs than digital/cryptocurrency pairs. In fact, some exchanges do not even accept any type of fiat currency at all. This is why many traders have no choice but to trade one cryptocurrency for another. Bitcoin (BTC) vs. Ethereum (ETH) gives you the BTC/ETH pair, for example.
As you can imagine, the thousands of different cryptocurrencies available for trading means the mixes and matches can be endless. Many cryptocurrency exchanges have rated these mixes by creating different “rooms” where you can trade the majority of the cryptocurrency you hold against a number of the most popular cryptocurrencies. For example, as you can see in this figure, the Binance platform has created four main cryptocurrency rooms or classes: Bitcoin (BTC), Ethereum (ETH), Binance Coin (BNB), and Tether (USDT). By clicking on each of these categories, you can trade other cryptocurrencies against the selected quote currency.
When trading currency pairs, fiat currencies or cryptocurrencies, your best bet is always to pair a strong base currency against a weak quote currency and vice versa. In this way, you can increase the chances of this pair moving strongly in the direction you are targeting.
The reason to diversify your portfolio is to reduce its exposure to risk by including fully uncorrelated assets. The biggest problem with diversifying within your cryptocurrency portfolio is that, at least at the time of writing, most cryptocurrencies are closely related to Bitcoin. Most of the days Bitcoin was having a bad day in 2017 and 2018, the majority of other cryptocurrencies were as well. The following figure shows, for example, a snapshot of the 12 most important cryptocurrencies on August 18, 2018. They are all in red. In fact, 94 out of the 100 cryptocurrencies by market cap were declining that day. (The market cap shows the value of all units of the cryptocurrency for sale at the moment.) In the crypto market, this kind of short-term market correlation has become the norm.
This correlation is one of the main reasons why short term cryptocurrency trading is riskier than many other financial instruments. It may be best to consider long-term investments when adding cryptocurrencies to your portfolio. In this way, you can reduce your investment risk by diversifying within different crypto classes.
On the bright side, as the cryptocurrency market continues to evolve, diversification methods could also improve, and the entire market could become less tied to Bitcoin.