Low correlation between cryptocurrencies [Crypto indexing part 3]
In the previous article we concluded that portfolio theory has had a huge impact on finance, still, portfolio theory has not influenced the cryptocurrency market yet. There are thousands of cryptocurrencies, and many hundreds are traded on large exchanges. But out of the few people that have bought cryptocurrencies, owning only 1–3 different ones is the norm.
Just like different companies operate in distinct sectors, different cryptocurrencies try to solve different problems — some focus on building a general purpose scripting language and others on integrating their software with the current banking system. Just like stocks, cryptocurrencies have a correlation that makes them suitable to be put in a basket. As seen in Figure 4, the correlation between cryptocurrencies is even lower than the correlation between equities (see Figure 3 in the previous post). In this regard, indexing makes even more sense with cryptocurrencies than it does for the equity market.
One way to understand how diversification can work in practice is to consider the “performance reversals” for cryptocurrencies. For a long period, Bitcoin outperformed almost all other cryptocurrencies. But during the price drop of Bitcoin in January 2018, three of the top 10 digital assets — EOS, NEO and XLM — realized positive returns. Only twice in 12 months has the most profitable cryptocurrency repeated the feat of having the highest return in the following month. These performance reversals clearly demonstrate the benefits of diversification. It also provides a good reason to buy a slice of the market, instead of trying to pick a few assets and hope they will perform.
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Jacob Lindberg, the author of this post, is the founder & CEO of Vinter — an index provider and data analysis firm specialized in cryptocurrencies.
This blog post is a part of our intro blog series on crypto indexing. Read part 4 here
