Markets
The importance of diversifying digital asset portfolios to achieve optimal returns
Digital assets may be one of the few markets where diversification still seems undervalued. Bitcoin and Ethereum remain dominant in terms of market capitalization despite a growing number of innovative new projects, and many investment products provide only a handful of concentrated positions.
At Outerlands Capital we have written on the benefits of diversification for risk-adjusted returns. Individually, smaller projects may carry greater risk, but investing in a broad mix of projects can reduce volatility and improve risk-return metrics such as the Sharpe ratio (returns normalized for volatility). However, there’s more to diversification than higher Sharpe ratios.
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In a dynamic market like cryptocurrency, diversification is essential to gain exposure to the diverse and evolving mix of themes and sectors built around blockchain technology. Diversification involves the power-law solution to the distribution of returns, whereby a portfolio’s return is determined by a limited number of highly positive outcomes versus a larger number of investments that provide lower or negative returns. This phenomenon is well documented in venture capital (VC) investing, and the concept extends to investments in digital assets, which are similar to investing in disruptive technology startups. Diversification ensures your portfolio has enough shots on target to catch the biggest winners over time.
A concentrated portfolio of just a handful of tokens will struggle to capture the range of exciting cryptocurrency use cases being developed today. Take, for example, the 10 largest cryptocurrencies by market capitalization – a popular version of a ready-made “diversified” portfolio. Here you have, essentially, a mix of currencies and Layer 1s. While these larger tokens are sometimes seen as less risky due to size, such a selection fails to capture much of the current innovation taking place in the cryptocurrency industry.
Expand to an actively managed portfolio that includes tokens in the top 150 by market cap and you start to see a much more dynamic picture, spanning layer 1 and related infrastructure (such as scalability and interoperability solutions), DeFi (from trading and asset management lending), entertainment (including gaming and the metaverse), decentralized physical infrastructure networks (DePIN, including projects for distributed computing power with links to artificial intelligence), real-world assets (RWA), and more. While some of these projects may carry greater risk in themselves, diversification helps manage overall portfolio risk.
Portfolios should be positioned to capture emerging themes and new directions as projects across the space continue to innovate, seeking product-market fit. Even in the more developed parts of the crypto ecosystem, such as payments or Layer 1, we believe it is still too early to define the winners. The pace of innovation means disruption will continue to be the norm.
The birth of the market and its rapid evolution also mean that an active approach to portfolio management is imperative: diversified does not equal passive. Building a well-diversified portfolio isn’t simply about buying more smaller assets. It means taking a long-term perspective on the scope and scope of the digital asset ecosystem and positioning a portfolio to take advantage of the many different potential outcomes.
Coming from cryptocurrency conferences such as Consensus, AIMA Digital Assets, Token2049, and DAS, we are once again encouraged in our assessment that the average institutional crypto wallet is simply not exposed to enough of the disruptive use cases being tested in today’s digital resources. Emerging themes such as DePIN, innovative scaling solutions for Ethereum and even Bitcoin, and the transportation of real-world assets on-chain all require an in-depth look beyond the largest tokens and should encourage digital asset portfolios that span many sectors and project sizes.
Remember that diversifying doesn’t make a portfolio less powerful, it actually makes it so for investors Moreover opportunity to capture winners, while still providing time-tested risk advantages. In essence, diversification gives you more for less.
Disclosure: The information contained herein is for general information purposes only and does not constitute investment advice. An investment involves a high degree of risk. Past performance is not necessarily indicative of future results.