Most of you already know that digital assets like Bitcoin, Etherium, and Nonfungible Tokens (NFT) experience huge price swings or volatility. Today's focus is diversification of your portfolio and digital assets. When you choose from among different investment options, you diversify. You likely already started do this by investing in mutual funds or exchange traded funds through a workplace retirement plan like the Thrift Savings Plan or a 401k. If you have a portfolio of stock and maybe bond funds, what happens if you add in VERY volatile digital assets in the hopes of earning a bigger return (profit)? Will those stormy seas will turn into a tsunami of risky volatility?

Not necessarily. That’s due to correlation, the tendency of different investments to swing up and down together. Two investments with a correlation of 1, are perfectly correlated, they go up and down together. If the value of investment A goes up, investment B also always goes up. If the value of investment B goes down, investment A goes down too. This could be the stormy seas turned tsunami scenario. If you need that invested money for something else, you’re going to take a loss.

If two investments have a correlation of -1, they are perfectly negatively correlated, when one investment goes up the other always goes down. And vice versa. But just like unicorns, perfect negative correlation pretty much never occurs. it they have a correlation of 0, there is no correlation. If A goes up, B has an equal chance of going up, going down, or not changing at all.

The volatility, or price swings of digital assets is VERY high. Fortunately digital assets are NOT perfectly correlated to stocks, or any other assets. In plain English, most of the time digital assets values do their own thing and fluctuate in ways that do not match stocks or bonds.

Although Bitcoin is almost a decade old and many investors have jumped on the digital asset band wagon, the digital asset market is still more like the wild west than traditional investments. In addition to wild price swings, regulations and insurance programs that help protect investors of traditional assets haven’t developed yet for digital assets. Fees associate with buying, trading, and holding digital assets can be high and are often buried in fine print. If you do invest in digital assets, you literally need to be prepared for the possibility you could lose your entire investment.

Because digital asset prices are not strongly correlated to other assets like stocks and bonds they could be beneficial to broader portfolio. But be careful. Adding too much digital assets to a portfolio can have the affect of the tail wagging the dog. How much? Depending on your tolerance for risk probably just 1% to 5% of your overall portfolio. Yes, that small an amount could make a meaningful difference in your portfolio’s return, while managing the risk of price volatility and the very real uncertainty of the new investment type over all.

Always keep very detailed trading records. You are responsible for reporting and paying taxes on your profits and losses. If you’re a HODLer that buys and never sells, you won’t owe taxes until you eventually do trade or sell your assets. If you are an active trader, be very careful. You can wrack up a huge tax bill before you realize it if your unfamiliar with the tax laws, especially around short term capital gains, short term capital losses, and the wash rule. One way to minimize these problems is not to sell an asset within one year of buying it. If you plan to trade more often, seriously get some tax help.

For more information on investing, check out Ep 63 Crypto Currency, Ep 57 Risk Profile, Ep 52 Stocks, Ep 45 Rebalance, and Ep 44 Capital Gains.