Diversification 2016: Still The Only Free Lunch In Investing

In my personal study of investing best practices a few years ago, I came across this saying "Diversification, the only free lunch in investing". While there are many investment styles, I've found a well diversified portfolio to provide the most stability and lowest risk overall.

A well diversified portfolio is arguably even lower risk than holding all your investment funds in cash. This is because by holding only cash you risk the opportunity cost of your money not being in the market and growing. A well diversified portfolio will be relatively stable compared to cash but have the advantage that you are in the market also, ready to reap the reward of market returns over time.

What Is A Well Diversified Portfolio?

By well diversified, we are talking about diversification among asset classes. The major asset classes are stocks, bond, commodities and real estate. Within each asset class there are sub classes. Stocks can be broken into a few major sub categories such as U.S. stocks, developed world stocks (mostly Europe, Japan and other developed countries, although our world is rapidly changing and this definition may change or become irrelevant), emerging markets stocks ( the rest of the world). Bonds can be broken into sub asset classes similarly, as well as long term, intermediate term and short term bonds. Commodities are generally real world things like food, oil and gold (precious metals). Real estate of course is houses, buildings and property.

One easy way to invest in these is via ETFs (which are kind of like mutual funds but instead they just track "indexes" and commonly have much lower expense ratios than mutual funds). Some example tickers of ETFs for the above mentioned asset classes and sub classes are ...

SPY: S&P 500 - US Stocks
AGG: Total bond market
IAU: Gold
VNQ: Real Estate
VWO: Emerging markets

I believe there is also a new asset class emerging. It is currently a little fuzzy overall but it is probably currently best labeled "cryptocurrency" and or "blockchain technology". Cryptocurrency is still in the wild wild west stage and it is yet to be determined what all will come out of it and how it will take form. Here is an ETF ticker for bitcoin...

GBTC: Bitcoin

There is also the Winklevosses "COIN" ETF but I believe it still not trading at the moment. Unfortunately, to my knowledge, there does not yet exist and ETF that tracks cryptocurrency as a whole.

Cryptocurrency Should Be In A Well Diversified Portfolio

A common disclaimer I hear as I've studied cryptocurrency is "this isn't investment advise, but ... " . This disclaimer is given because cryptocurrency is highly speculative and highly risky. This is due to many factors, but mainly because of how new of "thing" this is. Because of this, I wouldn't invest any money in it you can't lose. That being said, It also has huge potential and it should be include as a small percentage of a well diversified portfolio.

Also, any investments in cryptocurrency should be diversified as well. There are many smaller "altcoins" but currently the main cryptocurrencies according to market cap are bitcoin, ethereum and now steem. This link http://coinmarketcap.com/currencies/views/all/ lists all cryptocurrency in order of market cap. A way to invest in them all would be the ideal scenario for diversification. This would be particularly ideal because many newer cryptocurrencies seem to cost very little. Just picking up $100 worth of them each, could lead to huge upside potential over time. Potentially even millions or billions.

The Potential Upside Potential

(NOTE: I have to include a huge disclaimer here because this scenario is highly speculative and just given as an example)

To put the upside potential into perspective, currently there is about $100 Trillion worth of money/value being stored. The units of store are primarily cash, government bonds and gold. Bitcoins market cap is currently about $10 billion and trading at ~ $650 per bitcoin. If bitcoin was ever able to establish itself an attractive unit of store compared to cash, government bonds and gold, and if it was able to take just 1% of that market share as a unit of store. That means bitcoins market cap would be at $1 trillion and make each bitcoin worth about $65,000.
Bitcoin still has a long way to go before it takes 1% market share as unit of store, but over time if it continues to be stable, the longer it exists, the more attractive as a unit of store I believe it will become.

This is a huge potential increase for someone who buys a bitcoin currently at $650 but what about those who bought bitcoin when it was much lower. If you already own hundreds or thousands of bitcoins, that scenario would make you a multi-million or even billionaire.

If bitcoin does not continue to be the cryptocurrency king and establish itself as an attractive unit of store, there is a possibility for another cryptocurrency, that may be currently selling for much lower to become that. In that scenario, one could currently buy this cryptocurrency for much less than the $650 bitcoin price. I'm mentioning this just to note how diversification is important and lowers your risk overall. Because we don't know all the possible outcomes, nor which one will happen, investing something in all of them would be the ideal. Currently since this is not possible or practical, we need to try to identify which cryptocurrencies or "altcoins" that are selling low have potential and which are junk.

In Conclusion

Cryptocurrency as a whole definitely has a place in a well diversified portfolio. It should should be a small portion due to the nature and newness of cryptocurrency. But by owning no cryptocurrency investments you are risking the opportunity cost of a huge upside potential. While I have been researching cryptocurrency, it seems the general consensus is that while everyone is not sure if bitcoin itself will survive in the long run, the "blockchain" technology it introduced is revolutionary and here to stay and transform the world in many ways.