Why Cryptocurrency Diversification Makes Little Sense

Anyone coming into crypto realizes very quickly that there are a lot of different coins out there. Bitcoin, Ethereum, Ripple, Litecoin, Bitcoin Cash, Tron, Cardano… How is an investor supposed to figure out which ones to invest in?

There are many arguments to be made about why diversification in cryptoassets makes little sense, including the network effect of money, but in this article, I’ll make another argument as to why adding altcoins to a portfolio that has Bitcoin makes very little sense.

Why Diversify?

The traditional reason for diversification is to optimize the risk/reward ratio. By buying, say, 10 different stocks instead of 1, the thinking goes, you can reduce volatility and downside since your eggs are spread in many baskets. The purpose is reduction of volatility and downside to minimize the risk/reward ratio. There’s a whole field devoted to doing this called Portfolio Theory, but the goals of diversification are pretty clear: reduce the risk of permanent loss and reduce volatility.

When someone chooses 10 stocks for a portfolio, the stocks typically already meet some minimum requirements. For example, they’ve met some requirements by the SEC in terms of transparency, their history is available to the market and they’re under threat of penalty if they cook their books. This is to ensure that the marketing story about a stock has to conform to the underlying reality, especially their prospects and financial condition.

Diversification in this context may make sense because there’s good reason to believe that the story being told about the stock by the company is close to being true. The unstated assumption is that the risks and rewards around a stock are understood. That is, the error bars around the risk are not too big and there are good reasons to believe that the companies being considered are telling the truth. Hence diversification in a stock setting makes sense if the risks and rewards are reasonably understood.

The Story vs. Reality of a Cryptocurrency

The reality of a cryptocurrency is in the code which, unfortunately, is very dense, hard to read and impossible to understand for a large amount of people. Because cryptocurrencies exist in the digital realm, the code and the network that secures it is the reality. While the ability to analyze the underlying reality is there, it’s just not practical for most people, even experienced developers, to study the code underlying a cryptocurrency in less than a few months.

On the other hand, there is usually an abundance of marketing material about a cryptocurrency. These are stories of what the technology underneath can do and speculate on use-cases envisioned by the creators. These are often whitepapers that purport to show the details of the actual system, but are not rigorously defined like code is. This is documentation that’s more understandable, and often precedes any code that gets written.

In cryptocurrency, because of the difficulty and/or expense of evaluating the underlying reality (that is, the code), the marketing story is used as a shortcut. A few may evaluate the code (if it’s available), but most use the marketing story because it’s cheaper and easier.

Disconnect between Story vs. Reality

This brings up the question, just how divergent is the marketing story vs. the underlying reality? As brought up earlier, in a stock market, the two cannot diverge much without some serious penalties. In cryptocurrency, there is no enforcement mechanism to force the story and the reality to conform. Instead, there are incentives to over-promise on the story and under-deliver on the reality.

Embellishing the marketing story will result in higher price as most people will use this shortcut for their evaluation. What’s more, the reality doesn’t need to be delivered immediately and that gives the coin’s developers plenty of excuses to delay. Given that it’s an order of magnitude harder to disprove a story than to tell it, the over-promising has a good chance of not needing much defending beyond “we’ll get to it later”. In other words, exaggeration in marketing doesn’t cost much but adds a lot of demand. This is in contrast to the stock market where such exaggeration will incur some penalty.

Under-delivering the reality is another clear win for the coin’s development team. Promises that cost too much to deliver don’t have to be delivered at all. After all, they often already have the money. What they do deliver has no need to meet any sort of technical standards, either. Since it’s costly to evaluate the code that they do deliver, most people just stick with the marketing story and don’t bother much with the technical reality. The implementation can be a complete mess, the security can be unaudited, the tests can be unwritten and nobody would be the wiser.

What we find is that the incentives are such that there’s much reason to over-promise and under-deliver. The perceived reward, which is essentially a quantification of the marketing story, is perceived to be high. Since that’s the metric most people use, the price reflects a very optimistic future. As a result, the risk/reward ratio gets very high as permanent loss of capital becomes more and more likely.

In this sort of environment, it’s no wonder that so many scams have run amok.

The Consequences

By having so many people rely on the marketing story instead of the technical reality, and given the incentives of over-promising and under-delivering, we have ourselves a giant mess of an industry. Most coins are not vetted beyond the marketing story making sense (and sometimes, not even that!), and result in a giant inverted trust pyramid with the founder at the bottom.

The technical reality is usually only understood by a few and everyone else trusts that what the creators put into the whitepaper reflects reality. There is nothing to really enforce that the story and reality conform, and instead the information about the coin comes from a small number of people that created the coin. ZCash might have some incredibly interesting technology, but there was a counterfeiting bug for a very long time. And this is one of the more responsible altcoins, so how much more are the other ones hiding vulnerabilities?

This means that most coins in the industry have very high risk profiles. Most of them have no hope of achieving what they purport in their marketing story. Most have no track record of delivery and can be fairly characterized as unresearched. If these were stocks, they’d be sent to the pink-sheet and have a very low price due to the risk premium. Diversifying into unresearched pink sheet stocks doesn’t reduce risk, nullifying the point of diversifying.

What about Bitcoin?

You may be asking at this point, isn’t this true of Bitcoin? That would be a fair question, but the answer would be no. The reason is because Bitcoin has been pored over technically by thousands, if not tens of thousands of people over the years. Even when the whitepaper first came out, it wasn’t the same environment we see today, where near everything gets an investment. When Bitcoin launched, few people were running nodes or mining, let alone trading it for anything valuable. The incentives for over-promising or embellishing the story weren’t there. Furthermore, the whitepaper accurately described Bitcoin and over-delivered. In fact, the whitepaper was written after the code!

Furthermore, given that Bitcoin was the first coin, Bitcoin has had a much larger scrutiny of its codebase. The obvious evidence for that is that altcoin creators often have to scrutinize the Bitcoin codebase to create their own coin. In addition, there are over 500 contributors that have had merged pull requests, making it the largest open source cryptocurrency project.

What about an altcoin that’s forked from Bitcoin?

At this point you might be wondering about coins that don’t diverge from Bitcoin very much. Litecoin, Bitcoin Cash, Bitcoin SV and others are essentially small tweaks to the Bitcoin codebase.

There are two questions that we have to ask here. First, what are the changes from Bitcoin? Second, how maintained is the codebase?

The first question is usually the easiest to answer and usually, the main difference is that the altcoin is centralized. The technical difference is generally small enough that including such a coin is not going to reduce risk or decrease volatility, nullifying the reason for diversification.

The second question is the much more important one. If the coin doesn’t maintain the codebase in the same way as Bitcoin, then it’s got a bigger risk. This may come in the form of a smaller development team, less developer activity or quality of merged pull requests. The changes to the code since forking can be evaluated to determine the underlying technical reality. This, too, is expensive and slow so most people don’t do it.

The case against including forked altcoins is simply that the quality is worse and that there’s no risk reduction. In other words, these coins can fairly be characterized as “worse” Bitcoins which don’t add the desired properties of risk reduction and volatility reduction to a portfolio.

So What Diversification Makes Sense?

We know Bitcoin is different from altcoins in many ways. First, Bitcoin is decentralized while altcoins are not. Second, Bitcoin at its creation did not have perverse incentives, whereas altcoins at their creation did. Third, Bitcoin has the largest market cap value.

Any exposure to this space, then, requires Bitcoin at a minimum. The question, then, is, what else do you put into your portfolio?

The answer here is to do your own research. The data out there is mostly marketing material, full of exaggerations and difficult or even impossible promises. As the non-Bitcoin coins carry pink-sheet stock level risk, the scrutiny needs to be much higher, not lower, than that put into Bitcoin. Thus, real research means evaluating the code.

If you don’t know how to read the code, or worse, if the code is closed source or not written yet, that should be a complete non-starter. The technical reality of the currency cannot be verified.

If you’re capable of reading the code, but don’t want to put in the time to do so, that’s also a non-starter. There simply isn’t enough assurance with such coins to know that the marketing story and technical reality aren’t divergent. Reliance on anything else, including the opinions of people on Twitter and YouTube are likely based on the biased marketing material and/or kickbacks and not the code, which has no obligation to conform to reality.

This, in turn, means that there will have to be a significant amount of research put in to qualify a cryptocurrency as investable. Given that the market caps and/or liquidity of most coins are tiny, the time researching such assets simply isn’t worth the effort as they’re likely uninvestable anyway.

Conclusion

Diversification in cryptocurrencies makes little sense. The marketing story and underlying reality are incentivized to diverge and proper evaluation of each coin very expensive. Investing in altcoins without looking at the code is the equivalent of diversifying into random pink-sheet stocks without doing any research. Such an action would add risk and volatility, not reduce it, nullifying the whole point of diversification.

In addition, given the incentives at play, looking at the code is itself likely a waste of time. This is why the pink sheet market volume is so tiny versus the NASDAQ or NYSE.

The one cryptocurrency that is sensible to invest in is Bitcoin, because it’s been qualified through its unique birth and continued maintenance through its 10 year existence. Diversification of a portfolio by adding Bitcoin really can add upside, reduce risk and reduce volatility (if it’s counter-cyclical). Adding unresearched altcoins does not and hence makes no sense.