Does cryptocurrency fit into a diversified investment portfolio?

05 November 2021

Does cryptocurrency fit into a diversified investment portfolio?

What it is, whether you should invest, and how you might go about investing in it - with commentary from Vinnie Gardiner (CEO of Vault Digital Funds), and Darcy Ungaro (Financial Advisor and host of the NZ Everyday Investor Podcast).

Unless you’ve been living under a rock, you’ve most likely heard about cryptocurrency and its climb to mainstream investing popularity. If you’ve been interested in investing in digital currency for a while but haven’t been sure how you might go about doing it, this article is for you! We’ve put together an insightful piece that also includes valuable input from the host of ‘NZ Everyday Investor’ podcast, Darcy Ungaro, and ‘Vault Digital Funds’ CEO, Vinnie Gardiner.

First off, what is cryptocurrency?

Just in case you’re not totally sure what crypto-currency is, put simply, it’s a form of payment that can be exchanged online for goods and services - AKA digital currency. The core difference between normal money (also known as Fiat currencies) and cryptocurrency is that cryptocurrencies are created using blockchain technology using distributed ledgers rather than using the traditional regulated banking system. You can find out more about blockchain technology here.

In practice this means that cryptocurrencies exist outside of the normal regulated banking system, they are controlled by computer code rather than Governments and have been largely unregulated.

There are almost endless different types of cryptocurrencies (Bitcoin, Polkadot, Dogecoin etc), just like there are different fiat currencies (government-issued currencies that can be better regulated and controlled) like the NZ dollar, US dollar, Euro etc.

Crypto has been around for a little over a decade, first appearing in 2009 - where it has since risen in popularity (especially in the last few years) due to a mix of things like; its potential for massive returns/gains, lack of Government control, easy access, and low fees. Not to mention the fact that many people see it as the future of money (meaning they believe it will be adopted as the main form of currency one day).

For many, the idea of cryptocurrency carries an air of uncertainty with the belief that it's a very risky investment. Even today there’s still a strong stigma of it being a haven for criminals with it essentially being an asset class that was materialised out of thin air, with no real assets or backing. The crypto industry however has begun to evolve, and as it does, so do the investment opportunities. It is now something nearly a quarter-million (of mostly young) Kiwis’ have begun to dip their toes into.

When it comes to investing, the general aim is to understand how much risk is involved and then maximise profits within that understood risk tolerance (you can read more on it here). This makes investing in crypto a hard pill to swallow and as many still don't really understand what it is (for the reasons above) - to the point where many more traditional investors consider it to be nothing more than a new-age form of gambling.

And so it poses the question - does cryptocurrency have a place in a diversified investment portfolio?

For a more detailed explanation of cryptocurrencies, check out the Cryptocurrency segment on Investopedia's website.

So, does cryptocurrency fit into a diversified investment portfolio? The short answer is, it depends. Let’s dive a little deeper into the things you should consider before investing.

Understanding diversification
Diversification of an investment portfolio basically means ensuring you’re invested in different types of investments (e.g. shares, term deposits, property etc), so that if one performs poorly, you have a whole heap of others to make up for that loss. For more detailed information on diversification, check out this blog.

How diversification applies to cryptocurrencies
However, the traditional idea of diversification only partially applies to crypto. This is because a traditional investment portfolio benefits from the fact that things like bonds tend to rise in value when stocks fall, helping an investor ride out any market downturns.

In the case of crypto, it has been argued that it is negatively correlated (referring to the extent to which assets perform in relation to one another, in this case meaning that the assets tend to move in the opposite direction) when paired with traditional assets in a portfolio. However, within the crypto market itself, they tend to be correlated as they often rise and fall together, meaning if one does badly they all will and vice versa.

Aside from the potential benefit gained by adding crypto to your general portfolio, you should also think about diversifying within the digital coin market itself. As is the case with diversification with more traditional assets, this does mean you could potentially be limiting your earnings, but by owning several coins instead of one you’ll at least have a higher chance of safely landing on the moon, opposed to simply having your ship implode halfway to mars (AKA you won’t have all your eggs in the one basket).

Other things to consider if you are going to invest is that there are lots of scams, and ICO (Initial coin offering) type coins that are likely to fail, and social media can heavily affect the performance of crypto. People with large social outreach & influence can create havoc, a great example of this is Elon Musk who’s notoriously known for being able to send coin prices either flying or plummeting, all from posting a tweet. (Check out Vox’s piece where they charted all of Musk’s tweets in relation to crypto performance.)

How much of an overall investment portfolio should cryptocurrency make up?

Given the significant volatility and high-risk profile of cryptocurrency, the general consensus for most is that crypto should only make up around 1-5% depending on your risk appetite. I.e. If you follow a core-satellite investing strategy, e.g. 80% core investments, 20% satellite - that could mean keeping your digital currency investments to 1-5% in the ‘satellite’ part of your portfolio.

Darcy from the NZ Everyday Investor shares a similar view:

“For the vast majority of mainstream investors who already have some wealth built up, possibly the wisest move could be to allocate a small 1-2% towards Bitcoin. No need to be a vegetarian to try the salad here, and there’s no need to bet the farm on it either. An investor needs to balance the potential for significant long-term performance with the extreme short-term volatility this asset is capable of. For younger ‘accumulators’ however, potentially a much larger allocation would be something to consider: Higher-risk investments take longer ‘to cook’, so, contrary to how many ‘investors’ (closet speculators) operate, a long-term buy/hold strategy could be the best way to ensure there’s a long-term benefit.”

Do you need to diversify within the crypto market itself?

I.e. investing in different types of coins/currencies.

While there are a few bigger and more well-known coins like Bitcoin that people often invest in when they first dip their toes into cryptocurrency, you can and should also think about diversifying within the digital coin market itself. Just like diversification with more traditional assets, it means you are lessening your risk by not having all of your eggs in one basket.

Here’s what Darcy had to say when asked ‘Should you diversify within your crypto investments?’:

“Absolutely. Like many traditional finance (Trad-Fi) principles, you can apply them in de-centralised finance (De-Fi) also – this is one of them. One example could be to think from the perspective of market capitalisation: Bitcoin (the granddaddy of them all) say at 80%, Ethereum (the rails that carry much of what’s being built) say at 15%, and then 5% allocated to your favourite smaller-cap projects. These ratios can provide a more optimal return with potentially less volatility, but then coming up with a rebalancing strategy is the next most important thing to consider!”

If you're going to invest in cryptocurrencies, where should you go to begin?

There are a few different options when it comes to starting your crypto investing journey. You can choose whether you want to do it by yourself through a direct platform, or whether you’d rather do it through a managed fund - each comes with their own benefits and drawbacks. Darcy and Vinnie have explained a few of the options below, so read on but keep in mind that whatever option you choose, you should do your own research first too!

According to Darcy, starting to invest “is the best part”. Here’s what he had to say when asked how someone could start investing in cryptocurrency:

“So long as you have a long enough time-horizon with your investments, even if you think you’re late, you’re not. The crypto-to-the-moon bus is indeed moving fast, but it’s taking regular stops on the way. Twitter, YouTube, and podcasts are the place to be here. This is still very much the ‘Wild West’ in some quarters, so any newbie should ideally soak in as much content out there as possible, before making a move. When ready, one could purchase and hold crypto directly, simply by getting a wallet set up, and then opening an account with a provider like Easy Crypto. In addition, there’s now a new Bitcoin fund (Vault Digital) available on the Invest Now Platform. As usual, it’s also wise to seek qualified financial advice before deciding to invest any significant portion of your wealth."

With managed funds being the core of 'Vault Digital Funds’ offering, Vinnie makes a great case for them. Here’s what he answered when asked ‘Why is a cryptocurrency ETF a good option? And how does it differ from how people have been able to invest in crypto in the past?

“Most NZ and indeed global investors who have entered the Bitcoin space to date, have come to it via an exchange, or via self custody, which is a bit of a DIY approach, and does have some risk. There are also risks to holding your Bitcoin on an exchange, or in a digital wallet. It takes time and a degree of know-how to educate and protect yourself from risk of loss, and many investors simply don't have that time or expertise to get it right. But when investing in the Vault International Bitcoin Fund, which in turn invests in globally listed Bitcoin ETF shares, the custody aspect is taken care of for you. Another significant benefit is that gains in the Vault International Bitcoin Fund incur 0% capital gains tax, whereas gains on direct Bitcoin ownership incur capital gains tax of up to 39%. The VIBF is taxed in accordance with the FDR (Fair Dividend Rate) methodology, which gives a maximum effective tax payable of 1.4% pa.”

To summarise - whether you choose to invest directly yourself, or go through a managed fund, there are benefits and drawbacks of both. A managed fund may potentially provide more security and save you time if you don’t want to go to the trouble of learning all of the ins and outs of the coins you are investing in. However, you lose a bit of flexibility in timing when exactly to buy and sell assets like Bitcoin, which is a 24/7/365 marketplace.

Whereas doing it yourself arguably holds more risk as you’re responsible for doing your own due diligence on each investment you make (and seeing as cryptocurrencies can soar or drop in a matter of minutes, if not seconds, it can be time-consuming and require a lot more involvement and monitoring.) However, you have the benefit of having more control, can build a portfolio exactly as you want, and can react quickly.

What does the future look like for digital currencies?

We may not know what stocks will do in the next month, year or decade - but for the most part, we can be pretty sure they’ll go up. Of course, this certainly can’t quite be said with crypto. Some think it’ll change the world and how we know and use money, and others believe it's just a big bubble waiting to pop. It is, however, becoming harder and harder to imagine a world and future where they don't exist.

We asked Vinnie where he sees the future of cryptocurrency heading:

“There are many global opportunities and headwinds facing Bitcoin and other digital assets. Regulators are perhaps beginning to recognise digital assets like Bitcoin may be here to stay, and are seeing the potential of central bank digital currencies. Increasing regulation is inevitable, and to my mind a good thing, and could ultimately hasten adoption rates. Adoption rates are rapidly increasing, up from 60m to 200m+ crypto users in the last 1.5 years.

The Lightning Network also increases Bitcoin’s potential as a payment rail, with the likes of Twitter, PayPal, Visa, and Mastercard showing interest. Bitcoin has now been adopted as legal tender in El Salvador, and more countries may follow suit.

The SEC has just allowed the first Bitcoin Futures ETF to list on 18 October, which turned over very significant volumes on its first few days (note that Vault does not invest in this Futures ETF as it does not directly hold the underlying Bitcoin)."

Every month very significant changes are occurring. I see this continuing, as more people and corporations recognise the potential of Bitcoin and other digital assets.”

Vault Digital Funds are new to the market, so if your interest has been piqued, check out more information about them and keep an eye out for the other funds they have in the pipeline here!

So... should you add cryptocurrency to your investment portfolio?

With the number of people investing in cryptocurrency for the first time, it’s clear that a lot of investors are answering ‘yes’, but before you jump on the digital currency bandwagon (or rocket ship) too, make sure you do your research and are comfortable with the risk you’ll be taking.

Here are a few things to make sure you consider:

  • The percentage digital currency will make up in your overall investment portfolio
  • Understand the risks and volatility cryptocurrencies have and therefore what risk you will be taking on
  • Whether you’re going to invest yourself via a crypto wallet, or go through a managed fund like Vault.
  • Your investment strategy and whether you hold one coin or diversify by investing in a few different coins
  • The fees and taxes you will be paying
  • Staying up to date on what’s happening in the digital currency world
  • Researching and having a plan to revisit and potentially re-adjust your strategy as the market changes

The takeaway from all this is that cryptocurrency is an exciting new asset, but it's still very much in its infancy and should be approached with caution. There’s a lot to take in, so it's more than okay to be a little overwhelmed and weary at first - but by setting yourself up with the right strategy and risk awareness you will be in a better position to traverse the crypto highs and lows.

This article is intended for those who love to read up and hear different opinions on digital currencies and should not be deemed as financial advice. We strongly suggest doing your own research.

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