Community Submission - Author: Anonymous
In the context of financial markets, diversification refers to allocating capital to different financial instruments within and across asset classes. The main goal is to reduce the overall risks that may arise from holding a single asset class, such as a stock, bond, commodity, or cryptocurrency.
The idea behind the diversification strategy is that a portfolio made of a wide variety of assets is more likely to give better long-term returns, while also reducing the probability of significant losses. Diversification can be achieved within a single asset class (e.g., investing in different types of cryptocurrencies) or across various asset classes (e.g., investing in cryptocurrencies, stocks, and commodities).
In general, a diversified portfolio will have a smoother variation in regards to its net value. Mainly because the assets that present a positive performance tend to neutralize the ones with negative returns. As such, it is important to consider the correlation between the assets that make up an investment portfolio. For instance, if a portfolio is made up of highly correlated cryptocurrencies, it will react to market influences much like a single-asset bag. Negatively correlated assets are more beneficial in terms of diversification because they respond differently to market forces and tend to move in opposite directions.
Other than that, diversification strategies may also take into account other factors such as the asset’s geographic location, industry niche, company size, and so forth. For example, holding stocks from companies that are located in different countries will generate a higher degree of diversification than holding a variety of US-based stock shares.
Within the crypto asset class, diversification may be achieved when an investor holds a broad variety of coins and tokens. For instance, they may look at different use cases when comparing blockchains and their cryptocurrencies, ranging from digital currencies to smart contract platforms, to supply chain tokens, and so forth.
People usually say that an investor should never “put all their eggs in one basket,” and this popular expression represents very well the logic of diversification. Although holding multiple baskets may incur higher costs and increased risk of losing one egg, it greatly reduces the chances of losing them all. Conversely, diversification limits upside potential as a single asset can exhibit higher positive returns.