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Don't listen to the crypto-gurus.
Diversification isn't about buying different tokens.
The truth ? Tokens are the least important part of your portfolio.
In this young industry, effective diversification requires a fresh approach.
Ready for the real secret ? Keep reading.
Table of contents:
Wallet-Based Diversification
Asset-Based Diversification
Layer-based Diversification
Category-based Diversification
Project-based Diversification
1. Wallet-Based Diversification
Before delving deep into the vast world of DeFi and planning asset allocation, the very first step every investor should consider is wallet-based diversification.
It's the foundational layer of diversification, ensuring that your funds are not only spread across different asset classes but also stored securely in various wallets based on their purpose and function.
Why Start with Wallet-Based Diversification ?
From vulnerabilities in smart contracts to platform hacks, there are numerous external factors that can put your investments in jeopardy.
Wallet-based diversification offers a proactive approach to mitigate these risks.
By diversifying the storage of your assets across various wallet types and segregating funds based on their purpose, you can ensure that even if one storage method is compromised, not all of your assets are at risk.
Types of Wallets:
Cold Wallets
These are offline wallets, disconnected from the internet, making them immune to online hacks or phishing attacks.
Use cold wallets to store the bulk of your investments, especially blue-chip assets that you plan to hold long-term.
This wallet should remain offline and be accessed minimally.
Hot Wallets
These are online wallets, connected to the internet, and are suitable for daily operations.
Hot wallets can be used for daily transactions, trading, or engaging with DeFi protocols.
Given their online nature, they should hold lesser amounts to mitigate potential losses from online vulnerabilities.
2. Asset-Based Diversification
Asset-based diversification is a cornerstone of investment, aiming to spread risks and potentially enhance returns by allocating investments across different types of assets.
Cryptocurrencies in the DeFi ecosystem can be broadly categorized into three main asset classes:
Stablecoins
These coins can act as a hedge against the volatile crypto market, a means of transaction, or even as collateral in various DeFi protocols.
While stablecoins are designed to minimize price volatility, not all stablecoins are created equal.
They differ in their backing, issuance mechanisms, and transparency. Thus, even within the realm of stablecoins, diversification becomes essential.
Example: USDC, USDT, FRAX, DAI, crvUSD.
Blue-chip tokens
These tokens are often the primary entry and exit points into the crypto market.
They form the backbone of most crypto portfolios and are often seen as a store of value or a long-term investment.
Bitcoin (BTC) and Ethereum (ETH) are the most notable blue-chip tokens.
High-risk tokens
These tokens present opportunities for high returns, especially in a bullish market.
However, they're susceptible to significant losses, market manipulation, and can be highly volatile.
This encompasses a vast majority of the altcoins in the market, outside of the blue-chip category. When constructing a DeFi portfolio, an investor should consider their risk appetite, market conditions, and long-term goals.
A well-diversified portfolio might have a majority percentage in blue-chip tokens for stability, a smaller allocation in stablecoins for safety, and a speculative portion in high-risk tokens for potential high rewards.
3. Layer-based Diversification
Layer-based diversification is an approach to managing risk in the DeFi ecosystem by considering the inherent complexities and interdependencies of projects that are built upon one another.
Understanding these layers can be crucial in assessing the compounded risks that come with using protocols that are built on top of other protocols.
Understanding the Layers
Layer-1 Projects (Base Blockchain Layer)
As primary protocols, they don't rely on other platforms' smart contracts.
Each has its own governance, consensus mechanism, and native tokens
Examples: @aave
Layer-2 Projects (Scalability & Optimization Solutions)
These projects are built on top of Layer-1 platforms, leveraging the security and infrastructure of the base layer but adding additional features or capabilities.
Layer-2 projects inherit the risks of the Layer-1 platforms they're built upon.
Additionally, they introduce their own risks, such as those arising from the added complexity of their smart contracts or potential vulnerabilities in their added features.
Example: @pendle_fi
Layer-3 Projects (Projects Built on top of Layer-2 Solutions)
These are protocols that are built on top of Layer-2 projects, adding another layer of complexity and potential functionality.
Layer-3 projects compound the risks of both the foundational Layer-1 and the intermediary Layer-2 platforms.
With each added layer, the potential for vulnerabilities or unforeseen interactions between layers increases.
Example: @Penpiexyz_io
Layer-4 Projects
These projects represent the pinnacle of complexity within the DeFi ecosystem.
Layer-4 initiatives often interact with multiple underlying layers, introducing cross-chain functionalities or advanced financial instruments like synthetic assets.
?? This layer presents added risks:
Complexity Risk
Increased potential for code vulnerabilities due to project intricacy.
Collateralization Risks
Volatility in collateral can lead to forced liquidations, especially in CDPs and synthetics.
Interoperability Issues
Differences in consensus mechanisms and token standards in cross-chain bridges can create vulnerabilities.
Pegging Discrepancies
Synthetics may not always perfectly track underlying assets.
Third-party Risks
Dependence on external data sources like oracles can be risky if they are manipulated or unreliable.
4. Category-based Diversification
This approach minimizes the risk associated with any single category's potential downfall or unforeseen challenges.
Here's an exploration of some key DeFi categories and the importance of diversifying among them: - Yield Aggregators
Lending Platforms
Decentralized Exchanges (DEX)
Perpetual Decentralized Exchanges (Perp DEX)
Real-World Assets (RWA)
Implementing Category-based Diversification
Avoid putting all assets into one category.
Investors should stay informed about developments in each category they're invested in. - Understand the risks inherent to each category type.
5. Project-based Diversification
Project diversification in DeFi should be one of the final steps in your investment strategy.
Prioritizing Fundamentals
Diversifying across projects won't serve much purpose if all your assets are tied up in one token or if they are all stored in a single wallet.
It's like building a mansion on quicksand; the foundation matters more than the decorative elements.
Relative Significance
Among the various diversification types in DeFi, project diversification is less important.
Starting with the Giants
For beginners, it's advisable to begin with the leading projects in popular categories.
They are usually more reliable and have a proven track record. Engaging with these platforms provides invaluable experience and insights into how DeFi works.
Venturing Out
Once you've gained a solid understanding and confidence from interacting with the top projects, you can explore lesser-known platforms and categories.
While project diversification offers a way to optimize returns and manage risks, it should be approached methodically and after ensuring that other critical diversification aspects are addressed.
And now you can move on to selecting specific tokens for your portfolio, but that's a topic for another article.
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