Crypto Diversification: Believe It or Not, You Actually Make the Most Money In Cryptos When You…
… overweight lower market cap coins.
At least, that’s the case according to an analysis I just did where I examined different diversification strategies across different coins between April 2, 2017 and December 23, 2017.
When crypto prices took a plummet this past week, I wanted to get an understanding of whether diversification across different cryptos could truly allow for limitation of risk. I asked around to see if anyone had done a similar analysis, and though I found some interesting results, nothing gave me the sort of quantitative, numerically-based answer that I was looking for, so I set out to scratch my own itch.
In order to answer my question, I came up with a simple methodology to see how diversification could affect total returns. Overall, the approach was fairly straightforward: I took historical snapshot data from coinmarketcap.com (many thanks to them, they’ve provided a great service so far) for the top 100 coins on April 2, 2017 (around when I first got into cryptos), combined it with data on the top 100 coins today, filled in and cleaned up some of the bad data, and then compared how a portfolio of cryptocoins would do under different diversification strategies.
My current strategy is to overweight Bitcoin and Ethereum, and spread out some remaining speculative dollars to other coins in the top 50 (by market cap) based on my knowledge and intuition. My hypothesis was that, with a little more diversification, I could protect against downside risk. What I learned actually ended up shocking me, and will totally transform the way I approach cryptos investing.
I tested a portfolio against the following four scenarios:
- A portfolio that invests 100% of its allocation to the top 20 coins by market cap (similar, but not quite, how my current portfolio is structured).
- A portfolio that’s evenly weighted across the top 100 coins.
- A portfolio that’s weighted by market cap across all of the top 100 coins.
- A portfolio that’s overweight smaller market cap coins — specifically, this portfolio buckets all coins by decile and assigns higher deciles a lower market weight than higher deciles in an almost, but not quite, linear fashion.
The results that I found were quite surprising, as you can see below:
The scenario that produced the highest returns was the one that was overweight smaller market cap coins.
To me, this was initially surprising, since I expected smaller coins and ICOs to fall off the map after some time had passed. And it’s true that some of them did. But if I really think about it, it makes sense. The newest and smallest coins have the greatest ability to grow, and “cheap” coins have a lot of room to move up. If those coins are backed by solid teams addressing a real market problem (or if they’re manipulated by a small group of people continuously), then it’s not surprising that they can produce the biggest returns.
Ultimately, it seems like investing in cryptos, at least for the previous 8 months, is more like investing in venture capital, rather than in stocks. A small handful of key investments can bring, by far, the largest returns.
With that said, there are a lot of risks in the crypto industry, and it’s possible that the coins that produced the biggest returns since April were anomalies, or that they had significant market manipulation, or I had bad data.
Going forward, I’m going to slowly start to re-weight my portfolio. I’ll be flattening out the amount I have allocated to the big coins and start taking the proceeds to invest in some of the smaller coins. Of course, past returns are no guarantees of future performance, so let’s see how things play out.
For anyone that’s interested in taking a look at the numbers yourself, I’ve included a link to a shared Google sheet that you can use below:
