Crypto Risk and Diversification

Diversification usually means owning lots of different things so that one failure cannot sink you. In crypto that idea breaks down quickly, because most coins rise and fall together. The decisions that control your risk are mostly about size: how much of your money goes into crypto at all, and how much of that goes into small coins. Then there is the question of who holds them.

Decide how much of your money is in crypto

The biggest risk decision comes before you pick a coin: the share of your total money that goes into crypto at all. Get it right and a terrible crypto year is unpleasant. Get it wrong and the same year changes your life.

Bitcoin has fallen more than 75% from a peak more than once, and ether and most smaller coins have fallen further. So test any allocation against a 75% fall. Say you have £20,000 of savings on top of your emergency fund.

• Put 5% in crypto, which is £1,000. A 75% fall costs £750 (£1,000 x 0.75), or 3.75% of your £20,000.
• Put 25% in crypto, which is £5,000. The same fall costs £3,750, or 18.75% of your savings.
• Put 50% in crypto, which is £10,000. The same fall costs £7,500, and your £20,000 becomes £12,500.

Then look at the way back. As Compounding and Drawdowns in Crypto shows, a 75% fall needs a 300% gain to get back to even. In the last case your £10,000 would sit at £2,500 and need to quadruple. Choose the share you could watch fall by three quarters without selling in a panic or changing how you live. Nobody else can pick that number for you.

Why twenty altcoins behave like one bet

Diversification works when the things you own do not move together. Holding twenty different altcoins looks diversified, but most smaller coins tend to move with bitcoin, and in a sharp sell-off they usually fall together, often harder than bitcoin does. Owning twenty of them gives you twenty tickers and roughly one bet: a bet on the crypto market, with extra volatility on top.

Take a made-up sell-off. Bitcoin drops 30% in a month. Your twenty small coins, held in equal amounts, fall between 40% and 60% each and 50% on average, so the basket as a whole is down 50%. Spreading across them cushioned nothing, because every coin was exposed to the same market. Over a full cycle it can be worse, since many coins from earlier cycles never returned to their old highs and some went to zero.

For a crypto holder, the real protection is mostly the money kept out of crypto.

Core and satellites

A simple structure helps. The core is bitcoin and ether, the largest and most traded coins, and holds most of your crypto. They are still volatile. Anything smaller goes in the satellites, each kept small enough that losing all of it would not matter much.

As an example, take a £2,000 crypto pot split 80/20:

• £1,600 in the core, in bitcoin and ether.
• £400 in satellites, spread across four small coins at £100 each.

If one small coin goes to zero you lose £100, which is 5% of the pot (£100 / £2,000 = 0.05). If all four go to zero you lose £400, or 20%. That hurts, but it does not end your holding. Put the same £2,000 into one small coin and a single failure takes everything.

Set a cap for any single small coin before you buy, such as 5% of the crypto pot, and write it down. It matters most when a coin is rising and you want to add more. Trades are sized differently, from the distance to a stop, and Risk Management and Position Sizing works through that maths. The daily issue sizes every call that way. Holding coins for years is a different game.

Stablecoins as the cash leg

You can keep part of your crypto in a stablecoin such as USDT or USDC, which aims to hold 1 US dollar. It gives you somewhere to park money between buying and selling without leaving the exchange. It is still a risk asset in its own right.

• Pegs can break. TerraUSD (UST), an algorithmic stablecoin, collapsed in May 2022. USDC briefly traded below 1 dollar in March 2023 when its issuer had reserves at Silicon Valley Bank, which failed.
• A dollar is a currency bet. If you think in pounds, a dollar stablecoin changes value with the exchange rate between the pound and the dollar, even while its peg holds.
• The platform risk remains. A stablecoin held on an exchange is exposed to that exchange too.

For money you need to keep safe in pounds, a stablecoin is a poor substitute for cash in a UK bank account.

Counterparty risk: who is holding your coins

Price is the risk everyone watches. The one that is easy to miss is counterparty risk, the chance that the firm holding your coins fails or freezes. Mt. Gox in 2014 and FTX in November 2022 both froze customer withdrawals, and customers waited years for partial recovery. In the UK the Financial Services Compensation Scheme does not cover crypto.

Yield products add a second layer. A platform that pays interest on your coins has to earn that return somewhere, usually by lending them out. Celsius, a crypto lender that promised high yields, froze withdrawals and went bankrupt in 2022. A high yield is a payment for taking risk, and that risk is often hard to see from outside.

Keep only what you are actively using on any one exchange, and do not put a large sum with a single lender. Coins you plan to hold for years can sit in a wallet you control, as explained in Crypto Wallets and Self-Custody Explained.

Rebalancing when the mix drifts

Once you have a target, prices will pull you away from it. A rally makes crypto a bigger share of your money at the moment it has become more expensive. Rebalancing means trimming back to the target.

Say your target is 10% in crypto. You start with £18,000 in savings and £2,000 in crypto, a total of £20,000. Crypto then doubles to £4,000 while the savings stay where they are. Your total is now £22,000, and crypto is 18.2% of it (£4,000 / £22,000 = 0.182). To get back to 10%, crypto should be £2,200 (£22,000 x 0.10), so you sell £1,800 and move it to savings. You have banked part of the gain, and a 75% fall from there would cost you £1,650 (£2,200 x 0.75) instead of £3,000 (£4,000 x 0.75).

After a fall the rule works in reverse and tops crypto back up, which is hard to do and the reason to write the rule down. It works inside crypto too: if a satellite runs from 5% to 15% of the pot, trim it back. Pick a trigger in advance, such as a check every six months or a drift of more than 5 percentage points. In the UK, HMRC can treat each sale or swap as a disposal for Capital Gains Tax, so keep records of every buy, sell and swap with dates and pound values, and check HMRC guidance or a tax adviser before rebalancing a large amount.

Key takeaways

• The share of your total money in crypto is the biggest risk decision; test it against a 75% fall.
• Most altcoins move with bitcoin, so owning twenty of them adds volatility rather than protection.
• Keep bitcoin and ether as the core and cap each small coin at a size you could lose entirely.
• Stablecoins, exchanges and yield products can each fail, and the FSCS does not cover crypto.
• Rebalance on a written rule, and keep records of every sale for tax.