How Does Diversification in Crypto Compare to Equities: A Present and Historical Evaluation
Diversification, often viewed as a complex concept, has served as a fundamental principle guiding investors in balancing risk and return. Harry Markowitz’s pivotal work in the 1950s laid the foundation for this now-ubiquitous framework, emphasizing the benefits of spreading investments across various assets to optimize returns while managing risk.
The 1960s introduced the Capital Asset Pricing Model (CAPM), which clarified that diversification was more about strategy than chance. This model presents a method of blending assets to achieve the right risk-return balance. By the 1980s, researchers like Robert C. Merton had empirically demonstrated that diversification wasn’t merely theoretical but also a practical means to smooth out the ups and downs of portfolio returns. In 1992, economists Fama and Booth (yes, that Fama) showed that the benefits were significantly more potent in small-cap stocks than in large caps due to the heightened volatility profile of small-cap assets and their embedded idiosyncratic risks.
However, the benefits of diversification seem misunderstood among many retail investors. Reinholtz et al. (2021) demonstrated that on average, participants believed a diversified portfolio was more volatile than a single-stock portfolio with less predictable return outcomes. This belief is in stark contrast to what has been observed empirically and through out-of-sample analysis. With this in mind, we first wanted to level-set with a brief history of diversification and the reason it is so ingrained in modern investment strategies.
We’ve been saying that diversification reduces risk for investors, but what are the actual numbers around this? Well, in 1977, Professors Edwin Elton and Martin Gruber (both heavyweights in the academic finance world) sought to find out. Their work, titled “Risk Reduction and Portfolio Size,” was published in The Journal of Finance in October of that year. It demonstrated that as the number of stocks held in a portfolio increased, the total volatility decayed exponentially. They used weekly returns of 3,290 securities selected from the New York and American Stock Exchanges (now known collectively as the New York Stock Exchange after the 2008 acquisition) from 1971 to 1974 to simulate the behaviour of portfolios as the total number of underlying securities increased. Below is a snapshot of their findings.
Since variance by itself doesn’t mean anything to most people, we’ve recreated that table below, replacing their “Total Risk” column (which was a function of Portfolio Variance and how much individual stock returns deviated from portfolio returns) with “Risk”. In this case, “Risk” refers to the standard deviation of returns, a metric commonly known as volatility in today’s finance industry.
What should jump out immediately is how high the risk of a single stock during that time period was. For the record, the annualized risk of Bitcoin is ~100% on average. This level of risk makes sense though, especially when considering the market environment prevalent during that era.
In the early 1970s, the United States faced a complex economic landscape, with inflation emerging as a prominent concern. This period was marked not only by surging prices but also by significant events such as the demise of the Bretton Woods system in 1971. President Richard Nixon’s decision to abandon the gold standard during this time introduced a volatile phase in which currency values fluctuated unpredictably.
Simultaneously, the stock market experienced a downturn from 1973 to 1974, with the S&P 500 index shedding nearly half of its value. This decline was largely attributed to the OPEC oil embargo, which had profound repercussions for the U.S. economy.
Amid these challenges, inflation remained the proverbial “elephant in the room,” reaching double-digit levels. This relentless rise in prices prompted the Federal Reserve to take action by raising interest rates in an attempt to bring inflation under control. If this narrative strikes a chord, it’s because many of these events hold direct relevance to our current world and the experiences we’ve witnessed in recent years.
Without getting side tracked by commentary on the current economic condition (we’ve written about that enough in the past), what Elton and Gruber did in their 1977 paper was quantitatively demonstrate the extent to which a portfolio could be de-risked simply by diversifying across different randomly selected stocks. In fact, to go from most risky position (a single stock) to least risky position (the entire market), an investor lowers his relative risk by over 60%. Using a single return step and back of the envelope math as an illustrative example, that’s the difference between $100 going to $30 vs $100 going to $75 in a sharp drawdown scenario. Now that’s a big difference.
The other notable takeaway — an investor has already captured the majority of the benefits in diversification just by having as little as 20 -30 stocks in the portfolio. This is why traditional equity managers will tell you that by the time you have 20 stocks in your portfolio, you’ve diversified away your alpha.
With cryptocurrencies being the next emerging asset class, the question presents itself. Does diversification provide the same benefit for crypto currencies?
TLDR answer: Yes. Yes it does.
We proceeded first with recreating the analysis shown above. Because of data availability, we started the data from Jan 1, 2021 and were only able to get returns for 85 tokens not including stables. For increased accuracy with more data points, we used daily returns instead of weekly. Having only 85 tokens limited the maximum size of our portfolio of course, but as it turns out, it didn’t make too much of a difference because we could already see the same trend emerging.
To ensure we weren’t just capturing outliers, we ran 1,000 iterations where possible to generate the different portfolios and calculated the average for each portfolio bucket. What immediately stands out, again, is the high volatility that comes from having all your assets in a single token. That shouldn’t be a surprise as anyone who’s spent time in the crypto space will tell you that crypto is the epitome of “No pain, no gain”.
However, what is very interesting is that you actually do see diversification play out in a very similar way to equities. Once you have 20–30 different tokens in your portfolio, you have already captured the majority of the benefits of diversification. The major difference though, is that an investor would only lower their portfolio’s volatility by ~34% on a relative scale whereas with the 1977 example, volatility was lowered by ~60%.
But a lot has happened since the 1970s. The fundamental structures of equity markets have shifted significantly due to factors such as increased correlations across markets brought on by globalization and enhanced credibility of the Federal Reserve, among others. Do the numbers from the 1970s even hold in today’s environment? The only way to tell is to rerun the same analysis…so that’s precisely what we did.
In our example here, we looked at stocks in the S&P 500 over the same time period, using daily data, ran 1,000 iterations with no repetitions where possible, etc. You can see that the risk of the average stock today is notably lower than it was in that 1970s period. However, the relative risk reduction of a fully diversified portfolio is also smaller, dropping by only -31% — a figure similar to that of a diversified cryptocurrency portfolio.”
When thinking through why this is the case, it’s important to keep in mind two variables. The first, as mentioned earlier, is that correlations across equity markets have been increasing across the board since WWII. This is demonstrated via a research piece published in the American Economic Review, and echoed by other pieces from the NBER, IMF, Morningstar, etc.
The second is that Fed Funds rates have been trending in one direction since the 1970s. Lower rates result in increased liquidity, and as the saying goes, “A rising sea lifts all boats”.
In short, the main takeaways from this are that:
- Investing in the S&P 500 is much safer than purchasing a single stock
- In today’s environment, a fully diversified S&P 500 portfolio lowers your risk by about a third
- Diversifying your crypto exposure gives you the same benefit
Whether rates will remain high is anyone’s guess, but if cryptocurrencies continue to develop as an asset class and follow trends and patterns as existing asset classes then long story short, diversification makes sense and it will continue to be an important tool to protect against risk in the cycles to come.
