Foreword: The author of the article, Audrey Charmant, believes that choosing low-relevant assets can help reduce the risk of the portfolio and increase the risk-adjusted return. If you combine cryptocurrency with US stocks, you will get a correlation close to zero, which is good for diversified investments. This article was translated by the "Blue Fox Notes" community "HQ".
After months of experimenting with my CryptoCurious portfolio, I came to the conclusion that if you want to add significant diversification effects to your cryptocurrency portfolio, then it won’t add more cryptocurrencies to the portfolio. achieve.
Nonetheless, it is important to have a sufficiently diversified portfolio of different cryptocurrencies because it will reduce the overall risk of the portfolio. In The Smart Investor book, Benjamin Graham believes that having 10 to 30 stocks in a portfolio can provide enough diversification .
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In fact, when the portfolio contains nearly 20 investment items of equal size and sufficient decentralization, the total risk of the portfolio (standard deviation of returns) is reduced by 70%. Increasing the number of holdings does not result in a significant risk reduction (Figure 1).
Figure 1: Correlation between total portfolio risk and number of shares held (%)
Standard & Poor's 500 Index is not related to cryptocurrency
It is a good state when the correlation between different cryptocurrencies is very different, but this has not been the case in the past four months. Most cryptocurrencies are highly correlated, which means that their price movements are synchronized (Figure 2).
Figure 2: The return correlation of cryptocurrencies (since November 2018), the top 10 market capitalizations are highly correlated
Why is it important to build relevance in the portfolio?
Choosing less relevant assets can reduce the overall risk of the portfolio and increase risk-adjusted returns.
Figure 3: Different types of return on investment (since November 2018) are highly correlated in the CryptoCurious portfolio.
With a CryptoCurious portfolio of 4 to 20 different cryptographic assets, their return on investment is highly correlated (Figure 3).
The correlation between the returns of different stocks in the US stock market is shown in Figure 4.
Figure 4: The returns of the traditional stock market (since November 2018) are highly correlated.
Figure 4: Return correlation between cryptocurrencies and traditional stock markets (since November 2018), close to zero.
In the past four months, the S&P 500 has a 98% correlation with the Nasdaq index because major technology companies are attributed to both indices. We are in a world where global assets are highly relevant.
If the cryptocurrency market is combined with the US stock market, it will get a correlation close to zero, which is a very good state for asset diversification.
A study on relevance from June 2017 also found the same result: other asset classes such as real estate, commodities, foreign exchange, bonds, etc., seem to be unrelated to Bitcoin (Figure 5).
Figure 5: source:
In terms of diversification, low correlation is superior to high negative correlation. In fact, when you have two assets that are completely negatively related, such as one asset gain of 5% and the other asset loss of 5%, this will eventually lead to a mutual offset. When the correlation between the two asset returns is low, both will receive irrelevant returns, and the impact of one asset on the other asset will be as small as possible.
In another case, in a serious economic crisis, whether it is stocks, bonds, commodities or real estate, most of the assets will move in the same direction, that is, the price will fall; there is no alternative but to continue to hold. But a properly constructed portfolio will eventually recover.
Build a hybrid portfolio
To benefit from the low correlation, I built a hybrid portfolio that includes 50% cryptocurrency and 50% US stocks.
How do you represent these two markets separately? I use the Standard & Poor's 500 Index to represent the US stock market because it is a diversified stock market index based on the market value of 500 major US companies. As for the cryptocurrency market, I use a diversification index built by myself, which is composed of the top 20 cryptocurrencies of the market capitalization.
Figure 6: The price evolution of the hybrid portfolio, with 50% of the results coming from the S&P 500 and 50% from the Top 20 encryption index.
Figure 6 shows the evolution of the price index since the beginning of the study. Half of this mixed portfolio comes from the S&P 500 and the other half comes from the top 20 crypto index. It will never be able to beat both markets, but overall risk is reduced and performance is diversified (Figure 7). The maximum volatility rate is significantly lower, from -30% of the 100% cryptocurrency portfolio to -18% of the hybrid portfolio, close to the S&P 500's maximum revaluation rate (-15.74%).
Figure 2: Since November 2018, the return on investment of the top 10 cryptocurrencies by market capitalization is highly correlated.
In order to study unrelated assets, we must adjust the portfolio on a regular basis. Adjusting the portfolio can help reduce the risk of downside investment. A study of the benefits of cryptocurrency algorithm adjustments shows that when the adjustment period does not exceed 60 days, the adjustment is profitable, and then the profit seems to decline, so I choose to adjust every month.
Figure 8: Price change of the hybrid portfolio (blue) after adjustments on the 24th of each month.
Figure 8 shows the price change of the adjusted mixed portfolio. The results are significant (Figure 9): monthly adjusted mixed portfolio yields (21.1%) are higher than unadjusted mixed portfolio yields (18.7 percent), while monthly adjusted mixed portfolios are less risky (40.84) % vs. annualized 42.9 %). The adjusted mixed portfolio can achieve better performance in 2 time periods than the unadjusted mixed portfolio (Figure 8 green box)
To benefit from unrelated assets, adjustments must be made. The adjusted portfolio performed better than the traditional mixed portfolio by about 2.5% (Figure 9). In the period when the two markets are less volatile, the adjusted portfolio performs better, which may be due to the compound effect brought about by adjustments with assets with near zero correlation.
1. A diversified portfolio with different cryptocurrencies is important because it will reduce the overall risk of the portfolio.
2. Choosing assets with low correlations will help reduce the risk of the portfolio and increase the risk-adjusted returns.
3. If you combine cryptocurrency with US stocks, you will get a correlation close to zero, which is very beneficial for diversification.
4. By adjusting the cryptocurrency/US stock portfolio on a regular basis, you can reduce risk and get extra returns.
5. Relevance will evolve over time, so these results may only be temporary, but they may no longer exist as the market matures.
Risk Warning: All articles in Blue Fox Notes do not constitute investment recommendations . Investment is risky . Investment should consider individual risk tolerance . It is recommended to conduct in-depth inspections of the project and carefully make your own investment decisions.