Portfolio allocation and cryptocurrencies [Crypto indexing part 9]
Even though there are thousands of cryptocurrencies of which hundreds are actively traded on exchanges, most people who have bought cryptocurrency only hold 1–3 different ones. By contrast, an investor rarely holds only 1–3 equities, although they did before Markowitz introduced portfolio theory. As the crypto market matures, people will probably hold a diversified basket of cryptocurrencies. This will be especially true for investors who primarily seek attractive risk-adjusted returns and does not identify with a particular coin or care to be a part of its community.
Market forces will decide which blockchain projects are important and which are not. Competition will wash out the bad cryptocurrencies and reward projects with a compelling vision, competent team, dedicated community, functioning applications. In the end, the best cryptocurrencies will win.
At Vinter Capital, we do not know who the winners will be. Nor do we do pretend to know. Instead, we have provided a cryptocurrency index designed for the passive investor. For further details about why indexing makes sense for financial assets in general and cryptocurrencies in particular, as well as evidence that beating the market is an unprofitable strategy, see part I.
When considering whether or not to invest in an asset, an investor should study the asset not in isolation but rather as a part of the entire portfolio. It does not make sense to exclude Twitter from an equity portfolio simply because the stock is too risky. Instead, we should compare the portfolio with and without Twitter. After comparing the two portfolios’ characteristics such as sector allocation and risk-return profiles, then and only then can the investor make a proper judgment of whether to include Twitter or not in his portfolio. This was one of the major ways in which portfolio theory changed finance.
Starting from a traditional 60/40 portfolio allocation of stocks/bonds, and then spicing up this portfolio with a 5% allocation to cryptocurrencies results in substantially increased historical returns, but only a marginal increase in the portfolio volatility. Thus, adding cryptocurrencies to a balanced portfolio increased the risk-adjusted returns (historically). The reason why is explained by Figure 5 and 6 below.
Let us be crystal clear in our analysis of why adding virtual currencies to a traditional portfolio should make the portfolio more attractive. In Figure 5 we see an extended version of the traditional “efficient frontier graph”. In this figure, cryptocurrencies are marked as blue triangles and traditional financial assets are marked as purple squares. Two efficient frontiers are drawn: the solid purple line represents the set of portfolios investors can have if she only invest in traditional assets, and the dashed blue line represents the set of portfolios an investor can enjoy if she invests in both traditional assets and cryptocurrencies. Thanks to the statistical properties of these assets-namely their returns, volatility and correlation structure — the efficient frontier expands to the left when including cryptocurrencies. Again, the ideal place to be in the upper left corner, implying that investors who include cryptocurrencies in their portfolio can enjoy higher risk-adjusted returns. The result is a logical result since adding cryptocurrencies provide the investor with more to choose from.
For an even deeper explanation and understanding than the efficient frontier graph, consider Figure 6. Correlation is the driver of diversification. When the correlations between the assets are lowered, the portfolio’s volatility is lowered too. Thanks to the low correlation between cryptocurrencies and traditional financial assets (observed in Figure 6) there is a diversification effect of adding cryptocurrencies to a portfolio.
More content from the author
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 the other posts on medium.com/vinter
