If you’re looking to mix things up with your traditional investment portfolio, cryptocurrency may serve to fill that role. The wildly volatile, speculative asset class has provided investors with both astounding returns and devastating losses.

                By                    John Csiszar

Many cryptocurrencies regularly post losses of 50% or more within months, weeks or even days, making millionaires out of some and destroying the savings of others.

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But, is crypto really a viable diversification option? Read on to find out.

What Is Diversification?

Diversification is a way to reduce the risk in your portfolio by allocating your assets to a variety of investments. To achieve optimal diversification, these investments will have low correlation with one another. The idea is that if you have two different investments that show a positive rate of return but do not always trade in lockstep, you’ll still achieve the same long-term return but with lower volatility.   

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Crypto’s Correlation With the Stock Market

The problem with using crypto as a diversification tool, however, is that it increasingly is becoming correlated with the movements of the stock market. According to Barron’s, Bitcoin’s correlation with the S&P 500 was just 0.01 from 2017 to 2019, making it an excellent diversification tool. Unfortunately, that total lack of correlation has all but vanished. In 2020-21, that correlation jumped up to 0.36; and, as of March 2022, it had risen to 0.49.  

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What does that all mean? Assets with a correlation of zero have no correlation whatsoever. A correlation between 0.30 and 0.49 indicates a moderate correlation, while a figure of 0.50 or higher indicates a strong correlation. In other words, Bitcoin is currently just a hair shy of showing a strong correlation with the stock market, which means that its value as a diversification tool is more limited than it used to be.

Which Cryptos Should I Consider?

When it comes to using crypto as a diversification tool, experts generally suggest sticking with the two “big dogs” in the space, Bitcoin and Ethereum. There are literally thousands of cryptos you can choose from; but, generally speaking, the smaller they are, the more speculative they become.

While Bitcoin and Ethereum are a far cry from Treasury bills on the risk scale, they are proxies for the crypto market as a whole. If you’re simply looking for diversification exposure to crypto rather than trying to speculate on a big winner, sticking with the industry leaders is generally your best bet.

How Much Is Too Much When It Comes to Crypto?

Although suggestions are all over the map, most financial advisors and experts in the field recommend a crypto correlation of somewhere between 1% and 5%, with very few recommending more than 10%. For example, Alex Doll, a CFP and president of Anfield Wealth Management, recommends clients don’t invest more than 10% of their “risky” assets in cryptocurrencies.

Anjali Jariwala, a certified financial planner, CPA and founder of FIT Advisors, recommends no more than 3%. Many advisors simply recommend that you shouldn’t invest more money in crypto than you can afford to lose. 

Is There Value in Using Crypto as a Diversification Tool?

Increasing numbers of investors are using cryptocurrency as a diversification tool, and there may be some merit to the strategy. Although correlations are rising, crypto remains a speculative asset class that is fundamentally different from the stock market.

The speculative nature of crypto remains a double-edged sword, as it offers both the potential for explosive gains and the risk of enormous losses. As such, experts agree that particularly when being used as a diversification tool, allocations generally should be limited to the single digits.

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