When investors see headlines of outsized returns on cryptocurrency (crypto) investments, it can be tempting to allocate outsized positions of a balanced portfolio to digital assets. However, high reward is typically associated with high risk, and crypto markets are no exception.

Concentrating your portfolio in any investment introduces higher levels of risk when compared to a well-diversified portfolio, hence the expression “don’t put all your eggs in one basket.”

Remaining diversified is one of our core beliefs, and this principle is even more important if investing in crypto, as concentrated positions can especially increase risk and uncertainty for long-term investors.

What are concentrated positions and why do they increase risk?

When a single investment makes up a large percentage of a portfolio’s total value, typically more than 10%, it is considered a “concentrated position.” Because the performance of different assets can vary in response to changing market conditions, concentrated positions can expose an investor to elevated price volatility (increased swings in investment value) when compared to a diversified portfolio.

In equity markets, the S&P 500® is an index of 500 different companies across a wide variety of industries and sectors. In a market rally, such as the one in 2021, the index may be up nearly 30%. However, an individual stock may be down significantly, such as Penn National Gaming Inc, which was down more than 40% over the same period. If an investor’s portfolio is over-allocated to an individual security which meaningfully decreases in value, or which fails to appreciate alongside the broad equity market, this concentration risk could severely impact the investor’s ability to meet their long-term investment goals.

How does crypto concentration risk impact a portfolio?

As many investors are aware, crypto markets are more volatile than traditional investments. In May 2021, for example, nearly every cryptocurrency dropped in value by double-digit percentages, wiping out nearly $1 trillion in a single day.

Bitcoin declined more than 50% in just two weeks, and then took three months to reach new all-time highs.

It is important to remember that crypto markets do not have traditional trading hours like the New York Stock Exchange, which is open from 9:30-4:00 pm ET Monday through Friday, with closed or shortened hours on certain holidays. Crypto markets are always open, and they do not rely solely on exchanges for trading to occur. Furthermore, some of the largest exchanges, such as Binance (which claims to have no physical headquarters) or FTX (headquartered in the Bahamas), offer traders significant leverage, up to 20 times (x) in some situations compared to a maximum limit of 4x for day traders in the United States. When markets are always open, there is naturally less liquidity at certain hours. Combined with the sizable leverage permitted, this creates a market of outsized volatility, leaving concentrated positions highly exposed.

Such extreme volatility can greatly impact a portfolio that is over-allocated to cryptocurrencies. As you can see in the chart below, a small allocation to bitcoin can increase returns while minimizing the impact to standard deviation, a measure of risk in a portfolio. However, allocating larger portions of a portfolio to bitcoin greatly increases the standard deviation, meaning the investor is taking on much more risk (Figure 1).

Figure 1. Concentrated Positions in Crypto Can Have a Meaningful Impact on a Traditional Portfolio

Portfolio Type Traditional Measured Crypto High Crypto
Portfolio
Allocations
60% S&P 500
40% Bloomberg Agg.
0% Bitcoin
57% S&P 500
40% Bloomberg Agg.
3% Bitcoin
53% S&P 500
40% Bloomberg Agg.
7% Bitcoin
Annualized Total Return 13.1% 15.0% 19.2%
Standard Deviation 10.3% 10.8% 12.4%
Maximum Drawdown -15.2% -16.1% -18.9%

Source: Bloomberg, L.P.

What action should investors with large crypto positions take?

U.S. regulators have specifically classified certain cryptos such as bitcoin and ether as commodities, akin to gold or oil, which puts them within the alternative investment space. Considering that we do not have a formal recommendation to invest in commodities, this indicates a small allocation opportunity for crypto in a diversified portfolio. We think prudent investors should avoid concentrations both in their total crypto allocation (just as they would with any other investment asset class) as well as in their allocation to specific coins or tokens (similar to avoiding large individual equity holdings within a broader equity portfolio).

Managing a concentrated position in a volatile investment like crypto creates certain considerations for investors. The most straightforward action is to sell the assets, either at one time or over a predetermined timeframe. However, if the cryptocurrencies have appreciated in value, the investor could incur significant capital gains tax as a result of the sale. Although taxes can be a hindrance when considering the sale of a concentrated position, the tax consequences should not outweigh careful investment decisions. Developing a plan with your advisor to help minimize the tax burden over both short- and long-term time frames can help improve long-term risk-adjusted performance results, even net of taxes paid.

Diversification within crypto can be a daunting exercise considering there are more than 9,000 coins and tokens in existence and new digital assets being created routinely. There are multiple types of crypto, and diversifying across categories can potentially be a means to avoid concentration risk. While there are a limited number of traditional investment vehicles available for crypto investors, there are also a few smaller-capitalization stocks that provide exposure to the ecosystem without investing directly in crypto. These include crypto mining enterprises, crypto asset managers, and exchanges that offer crypto trading, all of which offer the possibility for minimizing crypto concentration risk.

Exercise Crypto Caution

Though chasing crypto returns can be tempting, we believe prudent investors should ensure that cryptocurrency allocations do not introduce unnecessary concentrations to their portfolios.

The volatility of the crypto market adds a heightened level of uncertainty to a portfolio, but managing concentrated positions, whether by maintaining a maximum allocation limit or diversifying within the crypto ecosystem, can help decrease risk.

A well-diversified portfolio with appropriate levels of risk best situates investors to achieve their long-term investment goals.