Optimal Crypto Portfolio
Using traditional investing wisdom to optimize your crypto gains.
What is the most effective way to invest and how can that framework be applied to crypto?
Let’s start with the framework. How do we learn to maximize profit?
I propose two ways to answer that question:
- The first is the scientific method / academic approach, which is to say academic literature, data, and hypothesis testing.
- The second is analyzing the most successful people to have done it and copy the things that worked for them.
In the real world, it is likely a blend of the two. The scientific method is the single most powerful framework that has allowed the progress of civilization. Yet, it can be slow and available information can be limited. Despite this, to invest most effectively, academics should be at the base of investing.
“But, I don’t want to spend years of my life getting a PhD in finance…”
And I don’t think you have to.
Here is an MBA level investing class smashed into a few paragraphs:
The base framework of academic knowledge needed to invest effectively is captured in two concepts: Modern Portfolio Theory and Factor Investing. If you understand these two ideas, congratulations, you are as smart as an MBA.
Modern Portfolio Theory (MPT)
- Harry Markowitz invented MPT in 1952 and won the Nobel prize for it.
Each asset has a risk/return profile. In general, the more risk, the more return. (This is obvious, but people seem to forget that return should make sense as a function of risk) The core concept of MPT is: by diversifying you can increase your expected return without increasing the amount of risk.
The efficient frontier is the answer to the question: How much should I invest in each asset to gain the maximum return at a given level of risk? You don’t need to know the math (but it helps: watch this MIT Lecture And This One)
The simple version is: Plot each asset on an XY axis as Return/Risk. (Expected Return divided by Risk is known as the Sharpe Ratio) Note that here risk is defined as price variance. Then by combining uncorrelated assets in various proportions you will be able to produce greater return per unit of risk. Thus using MATH you get the efficient frontier (black line seen below).
Next, draw a line from your risk free rate to the tangent of your efficient frontier and that point on the graph represents your optimal portfolio. This Capital Allocation Line (CAL) represents how much you should be holding in cash (well risk free treasury bonds technically) vs how much in that optimal portfolio depending on your level of risk aversion.
So what the heck does that mean in practice? How much of each crypto should I be holding?
Step 1: Select a minimum of 10 to 30 cryptos. The greater the number, the greater the benefits of diversification but gains beyond 30 are relatively small.
Step 2: Select assets that are as uncorrelated as possible. (Plug them into my excel tool or find a site that calculates this for you.) Example
Step 3: Use an efficient frontier calculator to tell you the optimal percentage of each crypto to hold.
Step 4: Use market indicators to choose your level of risk and thus what percentage of risk free asset you should hold. ( See future article: Optimal Crypto Portfolio Part 3)
Step 5: Invest your risk-on money according to the optimal percentages from step 3.
Three shortcomings to be aware of:
- Often crypto projects are extremely new. The less history, the less reliable this process is.
- Correlation levels are shifting rapidly in crypto. The higher the correlation, the less MPT works.
- In MPT risk is measured by variance. This may or may not be the best way to quantify risk.
I am Lazy… I don’t want to do all that. Just give me the short cut.
When you look at new projects, try to find ones that you think will be uncorrelated to what you already hold.
Congratulations you are halfway to an academic investing framework. Next week, Optimal Crypto Portfolio Part 2 will cover Factor Investing and how to make more money.