What is diversification

Crypto for Advanced
> 2 min. read
What is diversification

Diversification is a type of risk management strategy, which can be used with trading with stocks, CFDs or with cryptocurrencies. Its main purpose is to lower the risk of investments. The logic behind it is, that trader does not put all of his invested money into one asset class but makes a diversification and rather invests into more different.

With classical trading or investing this would mean that trader puts his money, which is intended for investing or trading, into for example stocks, indices, and commodities. If one decides to only trade one asset class, he can do the diversification as, for example, investing money in gold, oil, and coffee. When we talk about trading cryptocurrencies, the logic and principles remain the same. Instead of putting all money on Bitcoin, one can lower the risk with investing the same amount in Bitcoin, Ethereum, Ripple, etc. The idea in the end is that the performance of positive investments will outweigh the negative investments.

According to studies and mathematical models, the greatest cost-effective level of risk reduction is achieved by maintaining a well-diversified portfolio of 25 to 30 different assets. Investing in more assets provides more diversification benefits, albeit at a much slower rate. Diversification aims to smooth out unsystematic risk occurrences in a portfolio by ensuring that the positive performance of some investments balances out the negative performance of others. Only if the securities in the portfolio are not completely correlated—that is, if they react to market factors differently, frequently in opposing ways—does diversification pay off.

Advantages of diversification are reduced risk in portfolio, which also means that it somehow protects traded from the market volatility and offers higher returns in long-term investment.

Disadvantages are in the first-place limitation of short-term investment gains, as well as it costs trader more of transaction fees or commissions. This type of strategy can be also more time-consuming to manage.

Based on information above, each trader should consider for himself, which kind of strategy he wants to go with and if diversification strategy suits his goals and idea of trading and investing. However, if lower risk investments are more suitable for you, this would be a good pick. Majority of hedge funds are using this technique, as they are investing into multiple asset classes to minimize the risk and therefore protect their client’s investment funds.

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