Diversifying Your Portfolio With Crypto: A Step-By-Step Guide
Efficient portfolio management is the spine of every successful investment strategy. It involves the flexibility of knowing how and what to invest in concerning your risk tolerance and time horizon. One of the few secrets to a successful investment plan is diversifying your portfolio to balance risk and reward across your assets.
What is a portfolio?
A portfolio is a collection of financial assets or investments held by individuals or corporate organizations. There are different types of portfolios, some of which include income, conservative, and aggressive portfolios. Portfolios comprise financial assets like bonds, stocks, ETFs (Exchange Traded Funds), real estate, precious metals (like gold and silver), and cryptocurrencies.
What is portfolio diversification?
Portfolio diversification is a financial strategy that spreads your investments across several assets with disparate expected risks and returns. It is designed to reduce and limit investors’ exposure to the downside of volatility on any asset in their portfolio. The approach conceptualizes not putting your eggs in one basket.
Benefits of diversifying your portfolio
- It limits the impact of volatility on your portfolio by reducing asset-specific risk.
- It reduces the magnitude and intensity of a particular market downtrend across your portfolio.
- It balances your portfolio’s risk and reward.
- It helps to improve long-term portfolio performance.
Let’s say you have five assets in your portfolio; if two are experiencing a market downtrend, the others might be experiencing steady growth. This is possible because assets perform differently in different economic trends.
So while some investments are underperforming, some may be performing well, which might, in turn, cover losses accrued from the underperforming assets, resulting in an overall positive for the portfolio.
Why consider cryptocurrency as part of your portfolio
Cryptocurrency is an asset that holds significant economic potential. Its overall market capitalization portrays it as the future of finance due to its perpetual use cases. Crypto evolved in 2009, came into the limelight in 2013, and as of 2023, it has recorded over $1T in market cap with over 22,000 crypto tokens currently available. Its massive adoption has made crypto a financial hub for decentralized projects like the Metaverse, Web 3.0, NFT, DeFi, etc.
Understanding cryptocurrencies
Cryptocurrency is a digital or virtual currency spent on decentralized networks as a store of value and a means of settling debts. It is a P2P (peer-to-peer) digital currency transferrable within its native blockchain network and other specified networks through the wrapping process. As fiat money exists and is restricted to the physical world, cryptocurrencies replicate the same features of fiat money on decentralized networks and act as the landscape's (decentralized space) legal tender.
One of the critical features of cryptocurrency is high volatility which makes its prices rise or fall rapidly due to market trends. Cryptos are secured by renowned blockchain technology, which ensures safe and seamless transactions of these virtual currencies. The blockchain is the spine of cryptos and ensures that cryptos are not double-spent by their enthusiasts.
How cryptocurrencies work
Blockchain is a public ledger that records all digital transactions in its ecosystem. It verifies and validates transactions through a decentralized web of node operators called validators. Validators can be likened to bank officials that process financial transactions. Before transactions or spending can be approved, they double-check if the spender has the asset they are about to spend. After the transaction has been verified and approved, it is added to a fixed chain of other verified transactions. Validators are incentivized for the above work through the network's native token. These crypto incentives are the ones circulating across several exchanges.
Types of cryptocurrencies
Cryptocurrencies are classified into various categories, with some belonging to two or more of these categories. These include:
Cryptocurrency
This category might be broadly used to refer to every digital currency, but by their creation and blockchain relativity, only a few digital tokens qualify as cryptocurrency. Cryptocurrencies are usually native currencies of blockchain networks. Each crypto is the acceptable currency in its network ecosystem to settle debt and gas fees (transaction fees). Examples of such cryptos are BTC (for the Bitcoin blockchain network), ETH (for the Ethereum network), BNB (for the Binance Smart Chain network), and ADA (for the Cardano network).
Muslim Bitcoiner
Altcoins
Altcoins are alternative digital currencies developed after BTC. Thousands of altcoins are circulating, including ETH, BNB, LTC, and XRP. The advent of altcoins ushered in the concept of referring to crypto tokens as coins.
Stablecoins
Stablecoins are non-volatile cryptocurrencies pegged to fiat currencies like USD, GBP, and AUD. They have the same market value as their correspondents. The difference is that the pegged tokens exist on blockchains, while the fiat currencies are physical money but have the same value. Examples include USDT, USDC, and BUSD.
DeFi tokens
DeFi refers to Decentralized Finance. It is a financial ecosystem that offers financial services in the decentralized space (blockchain) using cryptocurrencies. DeFi mirrors traditional finance and provides a modified service to increase efficiency and seamless transactions without a third party or intermediary. Its primary concept is to rule out government or centralized authorities that create bottlenecks in traditional finance.
With DeFi protocols offering financial services like borrowing, lending, yield farming, and liquidity mining, they also have their native tokens, which they transact with. Examples of DeFi tokens include Aave (Aave protocol), UNI (Uniswap), SUSHI (SushiSwap), and DAI (MakerDAO).
Exchange tokens
Exchange tokens are crypto tokens issued by centralized and decentralized exchanges like Binance (BNB), KuCoin (KCS), and Gemini (GUSD).
Other categories of crypto tokens are utility, governance, security, and privacy.
How to get started
Before kick-starting your investment journey into crypto, you want to do the following:
- Define your investment strategy and goals.
- Define your risk tolerance.
- Choose cryptocurrencies that suit your investment goals.
- Conduct comprehensive research on your preferred tokens.
Once you’ve completed the above, get your crypto account set up. Start by choosing a reliable exchange and funding your account.
Part of investing in cryptocurrency is determining where you will store it. Some crypto investors prefer holding their assets on exchange platforms, while some prefer otherwise. Cryptocurrency is stored in wallets called ‘crypto wallets’. Crypto wallets are categorized into custodial, non-custodial, hot (software), and cold (hardware) wallets.
- A Cold wallet or hardware wallet is an offline wallet that stays off the internet. Examples include Ledger Nano, Trezor, and NGRAVE wallets.
- A Hot wallet or software wallet is accessible and resides online. These are split into two types:
- A Custodial wallet is a hot wallet managed by centralized exchanges (CEXes) like Binance, OKX, and Huobi. The private key to this kind of wallet is kept by the third party that controls these exchanges, so users are not in total control of their crypto assets. A downside to these wallets is that you’re putting your faith in a third party to look after your funds and give them back to you if you decide to trade or transfer them elsewhere (*coughs* FTX - read more about the scandal here). As they are held online, they are also subject to hacks.
- A Non-Custodial wallet is a hot wallet that grants users 100% control over their wallets and assets, including their private key. Examples are MetaMask, Trust Wallet, and Coinbase Wallet.
Since storage medium is a haven for digital assets, long-term investors mainly prefer cold storage because it is the safest storage that can hold crypto tokens without a security breach.
Benefits of diversifying with cryptocurrency
Cryptocurrencies offer a range of benefits for investors looking to diversify their portfolios.
New investment opportunity
The advent of cryptocurrencies unveils several investment opportunities like DeFi, NFTs, and lots more. Early birds can acquire crypto tokens at lower prices and sell them when their prices surge. Furthermore, cryptocurrency offers a financial market free from third parties or intermediaries, allowing all investors to be in charge of their assets.
High earning potential
Due to the high volatility of cryptocurrencies, prices of tokens can multiply as much as ten times their initial prices or even 100 times with time. Investors can participate in DeFi and subscribe to several passive earning protocols like liquidity mining and yield farming to increase earning potential.
Alternative to securities and other investment tools
Cryptocurrency has proven to be an alternative to securities like stocks, ETFs, sukuk, etc. Though crypto is volatile, the risks are worth the yield if done correctly. Rather than wholly investing in securities, investing a portion of your wealth into cryptocurrency can be worthwhile, especially during a bullish trend.
What are the risks?
Volatility
Cryptocurrencies are highly volatile; their prices are unpredictable and can swing downward and upward in a few minutes interval. Due to this, a well-performing crypto token can suddenly decline in value leading to a loss. Market sentiments and FUD (Fear, Uncertainty, and Doubt) created on social media typically influence crypto volatility.
Susceptible to scam
Like other investment tools, cryptocurrency is also prone to scams like rug pulling, exit scams, social engineering, meme coins scam, and fake tokens issuance. One of the best ways to avoid all these scams is to conduct comprehensive research on tokens before investing in them.
Lack of regulation
Cryptocurrencies are decentralized currencies that don’t require third parties to operate. As such, no central authority or government regulates crypto affairs. The lack of regulation scares many reputable individuals and corporate enterprises for fear of being outlawed. Furthermore, the lack of regulation makes some petty scams impossible to probe in court.
Security threats
Cryptocurrencies are also prone to security threats like phishing, eclipse attack, DDoS (Distributed Denial of Service) attack, and password or seed phrase theft. These security threats are launched to siphon victims' assets from their wallets.
Conclusion
Cryptocurrencies are laden with potential risks and rewards. It is essential to conduct comprehensive research before investing in any crypto token, and its upside can be huge when invested correctly. All in all, cryptocurrencies offer a valuable opportunity for portfolio diversification, and by delving into the world of crypto, you enable yourself to tap into an emerging and innovative technology.
Not investment advice. This content is for informational purposes only and does not represent legal, tax, investment, financial, or other advice.
Zoya: Halal Investing App
Zoya makes halal investing easy by helping you build and monitor a shariah compliant investment portfolio with confidence and clarity.