In this article, I want to tell you about diversification and its usefulness. Diversification is the investment practice that consists of investing in various financial instruments, such as assets, with the aim of being able to reduce the riskiness of our portfolio and, ultimately, potential losses.
Two types of risk
In finance we can distinguish two types of risks: systemic risk and ideosyncratic risk. Systemic risk is market risk. I'm talking about an event that affects all companies (if we talk about assets) of the same industry. So if we have an event that hits the tech sector hard, both google, microsoft and apple will surely suffer. Then we have another type of risk and that is the ideosyncratic one. The ideosyncratic risk reflects events that affect the single asset, the single company. An event that affects google, but it is not certain that it also affects microsoft.
Reduce risk by diversification
That said, you have probably understood that through diversification, we invest in multiple and different assets to minimize the effects of negative events affecting individual companies. However, the investor will never be able to reduce the risk to zero. There will be a threshold beyond which we cannot go down and that is systemic risk.
Diversification in the crypto market
In the world of cryptocurrencies, we now have hundreds of different coins. However, if we look at the prices, we can see that all of them, for better or worse, reflect the trend of the leading currency, bitcoin.
This phenomenon is called CORRELATION in statistics and describes the synchronous trend of two variables. The phenomenon can be observed simply by analyzing the graphs of the various currencies together with bitcoin. But if you don't trust it, you can always calculate what is called the correlation coefficient. To do this, you will need the covariance between the btc and the other currency you want to analyze and the two standard deviations. Said this, what are the implications for the practice of diversifying into cryptocurrencies.
Conclusion
Well... That said, what are the implications for practicing cryptocurrency diversification? Well ... obviously we are nullifying the benefits of diversification, if not making our situation worse. If we invest in instruments that are positively correlated, we are no longer canceling the ideosyncratic risk. Rather! An unwitting investor, convinced that he can diversify by investing in different cryptocurrencies, for a large sum of money, will be subject to more losses than investing a smaller sum, but focused exclusively on bitcoin. Of course, there are price deviations. They involve events for specific currencies, but the price still remains correlated with the main currency.
Two types of risk
In finance we can distinguish two types of risks: systemic risk and ideosyncratic risk. Systemic risk is market risk. I'm talking about an event that affects all companies (if we talk about assets) of the same industry. So if we have an event that hits the tech sector hard, both google, microsoft and apple will surely suffer. Then we have another type of risk and that is the ideosyncratic one. The ideosyncratic risk reflects events that affect the single asset, the single company. An event that affects google, but it is not certain that it also affects microsoft.
Reduce risk by diversification
That said, you have probably understood that through diversification, we invest in multiple and different assets to minimize the effects of negative events affecting individual companies. However, the investor will never be able to reduce the risk to zero. There will be a threshold beyond which we cannot go down and that is systemic risk.
Diversification in the crypto market
In the world of cryptocurrencies, we now have hundreds of different coins. However, if we look at the prices, we can see that all of them, for better or worse, reflect the trend of the leading currency, bitcoin.
This phenomenon is called CORRELATION in statistics and describes the synchronous trend of two variables. The phenomenon can be observed simply by analyzing the graphs of the various currencies together with bitcoin. But if you don't trust it, you can always calculate what is called the correlation coefficient. To do this, you will need the covariance between the btc and the other currency you want to analyze and the two standard deviations. Said this, what are the implications for the practice of diversifying into cryptocurrencies.
Conclusion
Well... That said, what are the implications for practicing cryptocurrency diversification? Well ... obviously we are nullifying the benefits of diversification, if not making our situation worse. If we invest in instruments that are positively correlated, we are no longer canceling the ideosyncratic risk. Rather! An unwitting investor, convinced that he can diversify by investing in different cryptocurrencies, for a large sum of money, will be subject to more losses than investing a smaller sum, but focused exclusively on bitcoin. Of course, there are price deviations. They involve events for specific currencies, but the price still remains correlated with the main currency.