Although cryptocurrency is a different type of asset than other investments, the traditional investing rules still apply. That includes the importance of diversification so that you can create a well-balanced crypto portfolio.

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For investors used to the stock market, cryptocurrency diversification presents new challenges. The risk and volatility of the crypto market makes it harder to find solid investments, and there aren't any index funds that let you buy a large group of cryptocurrencies in one fell swoop.

To improve your crypto portfolio, this guide will cover the most effective ways to diversify it.

What does it mean to have a well-balanced crypto portfolio?

A well-balanced crypto portfolio is one that contains multiple types of cryptocurrency with different use cases and risk levels. The investor allocates a set amount of funds to each cryptocurrency and rebalances as necessary when buying new cryptocurrencies or selling off holdings.

A crucial part of a well-balanced crypto portfolio is maintaining the balance between your crypto portfolio and your overall investment portfolio. Because cryptocurrency is a high-risk investment, it should only make up a small portion of your total investments. A good rule of thumb is to limit cryptocurrency to between 5% and 10% of your overall portfolio at most.

If your cryptocurrency investments increase in value, you may need to sell some so that your portfolio doesn't get too crypto-heavy. A portfolio that's 25% or 50% cryptocurrency puts you at significant risk if there's a market downturn.

7 ways to diversify your crypto portfolio

There are quite a few ways to diversify your crypto portfolio, and you'll find all the most common strategies below. Note that it isn't necessary to combine all of them. You can pick and choose the ones that work best for your situation.

1. Buy the market leaders

A simple option is to allocate your funds between the cryptocurrencies with the largest market caps. For example, you could stick to the 10 or 20 largest cryptocurrencies. These tend to provide more stability than smaller cryptocurrencies, although they are still volatile.

You'd normally exclude stablecoins with this method. For example, stablecoins such as Tether (CRYPTO:USDT) and USD Coin (CRYPTO:USDC) are among the top cryptocurrencies, but they're also intended to maintain a price of $1. Since these cryptocurrencies aren't designed to increase in value, you may want to skip them.

2. Focus on cryptocurrencies with different use cases

Cryptocurrencies have all kinds of uses, and these can be a good way to decide where you'll invest. Here are a few examples of crypto use cases:

  • Payment coins offer fast, low-cost payments anywhere in the world.
  • Decentralized finance (DeFi) platforms provide blockchain alternatives to traditional financial services.
  • Gaming coins are used to power blockchain video games.
  • Metaverse platforms have virtual worlds where users can explore and interact with each other.
  • Privacy coins offer untraceable transactions.

There are a variety of cryptocurrencies that fit into these categories. You could build your portfolio by first picking out several use cases and then investing in one or two cryptocurrencies that fit each one.

3. Invest in smart contract blockchain networks

Some of the most successful crypto projects are blockchain networks that can run smart contracts. A smart contract is like a program that runs on a blockchain. There are all kinds of ways smart contract blockchains can be used, including launching decentralized apps (dApps) and new crypto tokens, so this is a competitive space.

Since each blockchain has its own advantages and disadvantages, some investors spread their money around to several of them. Here are the cryptocurrencies for a few of the biggest smart contract blockchains:

4. Divide your portfolio into Bitcoin, Ethereum, and everything else

Although there's no such thing as a safe cryptocurrency investment, Bitcoin (CRYPTO:BTC) and Ethereum come the closest. Bitcoin is the largest cryptocurrency, and since Ethereum's launch, it has usually been second. Since they're the mainstays at the top of the market, they're more likely to stick around for the long haul.

If you want to weigh your portfolio toward the less-risky cryptocurrencies, you could prioritize Bitcoin and Ethereum. For example, you could use one-third of your crypto funds to buy Bitcoin, one-third to buy Ethereum, and the rest to buy any other cryptocurrencies that catch your eye.

5. Check out cryptocurrency stocks

Cryptocurrencies aren't the only crypto investment option out there. You can also invest in cryptocurrency stocks, which are companies related to crypto and blockchain technology. Since these companies provide a different type of exposure to crypto than investing in cryptocurrencies themselves, they're great for a diversified crypto portfolio.

6. Invest in smaller crypto tokens with greater growth potential

Part of the excitement of investing in crypto is looking for those smaller diamonds in the rough. Smaller crypto projects have a much greater risk of failure, but they can also be extremely profitable if they take off. While the bulk of your crypto portfolio should be in the top 25 to 50 cryptocurrencies, consider rounding it out with some smaller crypto tokens that you like.

7. Rebalance your crypto portfolio when necessary

Rebalancing is a key part of crypto portfolio management. As prices change, you'll likely need to buy and sell certain crypto investments to maintain a balanced portfolio. For example, if a few of your smaller investments increase in value, you may need to trade some of them for larger cryptocurrencies to keep your desired asset allocation.

Pros and cons of a well-balanced crypto portfolio

The biggest benefit of a well-balanced crypto portfolio is that there's less risk. When you have a diverse portfolio, you're not tied to the success or failure of any single cryptocurrency.

You also have better odds of investing in the most successful cryptocurrencies. We often see certain cryptocurrencies go through periods where they significantly outperform the rest of the market. The more cryptocurrencies you have in your portfolio, the more likely it is that you'll be invested in those outliers and can share in their gains.

While it's good to have a well-balanced portfolio, it's also time-consuming, which is the main drawback. Finding the right cryptocurrencies, deciding on asset allocation, and rebalancing your portfolio all take time. And, since the market is so volatile, a diversified crypto portfolio is no guarantee of success.

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Examples of well-balanced portfolios

Dallas Mavericks owner Mark Cuban has been a vocal proponent of crypto for years, and his blockchain wallet provides one of the best crypto portfolio examples. He has more than 100 crypto assets in his Ethereum wallet that cover a variety of use cases, with some of his largest holdings including:

Elon Musk revealed his crypto holdings in a tweet from October 2021, and he claims that he only owns three: Bitcoin, Ethereum, and Dogecoin (CRYPTO:DOGE). He doesn't have the most diverse portfolio, instead opting for simplicity with the two market leaders and Dogecoin, which he considers "the people's crypto."

It might seem daunting to put together a balanced crypto portfolio, but it's easier than it seems. You don't need a massive number of cryptocurrencies; even five to 10 is a good starting point. It's also not something that needs to happen overnight. You can invest in a few cryptocurrencies you know well and then gradually add more as you learn about new ones.

Lyle Daly has positions in Binance Coin, Bitcoin, Cardano, Ethereum, Solana, Tether, and USD Coin. The Motley Fool has positions in and recommends Avalanche, Bitcoin, Ethereum, and Solana. The Motley Fool has a disclosure policy.