Why diversification within crypto is more important than diversity with crypto.
The allure of cryptocurrency has captivated the imagination of investors worldwide and has been the entry point into investing for thousands of people who, prior to the rise of tokens, had never engaged with the act of purchasing and holding assets. Yet, amidst the rush for "digital gold," very little emphasis has been placed on investing best practices; especially on the boring but sensible old methodology of diversification, where you spread your wealth across various assets to minimize the fallout of a single loss.
This oversight may be partly because traditional financial companies (known as CeFi or TradFi in the industry) have, until recently, mostly dismissed crypto as an insignificant and whimsical project of the engineering class. Additionally, the vast majority of voices in the crypto space have been relatively inexperienced investors who—for the most part—don't trust the TradFi system, so they wouldn’t listen to them anyway, even if they had taken crypto more seriously earlier on. All of that aside, however, the diversity of assets is important, even for our so-called “DeFi DeGens.”
Now, when I say diversity of assets (aka diversification), I am not necessarily adopting the traditional financial advisor stance of “crypto as X% of your wider portfolio of Y & Z assets,” where you invest a small amount (usually around 3%) of your wealth in some well-known crypto assets. Indeed, this is a type of diversification, and a respectable one, but it treats crypto as one homogenous asset class, which it is not.
What I am getting at is diversification within a crypto portfolio, not just using crypto as a diversifier itself. There are a few reasons for this. Firstly, crypto assets are very much investable and quite disparate in their quality and returns. Our company, The Medici Project, recently went to great lengths to prove this with our crypto asset rating system. Secondly, quite a few people invest heavily (or in some cases solely) in crypto because they don’t trust traditional asset classes, or have no access to them (in the cases of investors who are in more financially constrained areas of the world). Thus, for these people, diversification is especially critical when their asset focus is much narrower than someone who has exposure to stocks, real estate, and private markets.
So, how does one diversify in Crypto?
The most obvious answer might simply be "buy a lot of different tokens," and although nominally correct, if all your tokens have a similar beta (meaning they all move together), then you've achieved as much diversity as a consulting firm filled with MBAs who all graduated from the same Ivy League schools. Sure, they may all physically look different and speak with different voices, but deep down, they all think the same (sorry, McKinsey).
Instead, I believe the best way to achieve real diversity in crypto investing is to focus on splitting your capital between different investment types; specifically, investments that you hold for appreciation, and other investments that you hold for income.
Diversification Through Income
While traditional income investments like bonds and real estate have long been staples in the diversification playbook, the crypto world, too, has its own income-generating assets: Liquidity Pools (LPs).
LPs are a particularly interesting instrument because they benefit directly from the usage of the crypto ecosystem. This means, as volume increases, so too generally does the yield you can derive from LPs. This has a nice dual benefit for diversification; firstly, it provides a different method to earn yield from crypto (as previously mentioned), but secondly, it also means that the yield on your LP investments tends to increase as the prospective risk of over exuberant trading increases in the appreciable crypto market (the market where value is derived from the increase in the value of tokens).
However, this introduces a second issue to consider: What tokens are invested in your LPs? After all, if you own Token A and then stake some of Token A in a liquidity pool to generate yield, you have not diversified. If Token A goes to zero, sure, you can offset some loss with the LP yield, but you'll most likely still lose out.
To address this, I present the most boring but best form of diversification you can have in the crypto space: Stablecoin LPs.
Stablecoin LPs
For those uninitiated, stablecoin liquidity pools (LPs) might seem somewhat unexciting, but that's precisely the point. At its core, this approach leverages the stability of fiat-pegged cryptocurrencies, employing them in a manner where they generate yield by offsetting one side of a cryptocurrency LP. This strategy is beneficial for two reasons: Firstly, stablecoins are incredibly useful and in high demand. As of the time of writing, stablecoins represent only about 5% of the crypto asset market, but account for roughly 60% of transactions. This means that staking the tokens to provide liquidity to the market is always a needed service, and carries strong rewards (i.e., yield).
Secondly, stablecoins have proven over time to be just that—stable. This means you can generate yield from them without much risk to your principal investment. Compare this with an LP where you're staking ETH, for example. Although you may be able to extract some yield from the staking, if ETH's value plummets, your investment suffers significantly. Sure, stablecoins aren’t going “to the moon 🚀” anytime soon, but consistently strapping yourself to a rocket isn’t exactly the best strategy for survival. Sometimes, it's safer and more productive to stay grounded.
Get to the Point
In the quest for portfolio growth, the allure of high returns can be tempting. Yet, the big secret of great investors over the past century has been a "slow and steady" approach. Seasoned investors understand that true strength lies in balance. Integrating stable income streams into your crypto portfolio doesn’t just offer a hedge against volatility; it lays a foundation for long-term growth. For those looking to step away from high-risk-high-reward behavior, or simply aiming to eek-out some additional yield on uninvested crypto assets without moving them off-chain to purchase more traditional assets, stablecoin LPs are the go-to solution.
At The Medici Project, we’ve always been advocates for applying “new assets with old methods,” which is why our first fund was a stablecoin liquidity pool fund, dubbed the “Stable Income Fund.” Traditional finance (TradFi) may not yet fully grasp the intricacies of crypto, but it’s equally true that many investors in crypto don’t fully understand TradFi either. As with many aspects of life, the truth usually lies somewhere in the middle. With that in mind, stay safe out there, invest wisely, and every so often, ask yourself, “Am I really diversified enough?”