Long-standing generally accepted financial theory shows that diversification is not only good, but also improves the expected return per unit of risk. Unfortunately, the cryptocurrency industry currently seems to be overlooking this principle.
Equivalent to “TradFi”
A timely post from quantitative asset management firm AQR provides a straightforward “TradFi” equivalent to the under-diversification problem. In a post, AQR co-founder and chief information officer Cliff Asness rejected a recent paper that effectively asked the question, “Why not 100% equity?” — a thinking style that tends to resurface during bull markets.
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This blog details certain tenets of introductory financial theory, the main one being that owning one asset is not optimal.
“In Finance 101, we are generally taught that the choices should be divided into: 1) What is the best portfolio relative to risk? 2) What kind of risk should I take?” This new paper and similar papers confuses the two. If the best risk-to-risk portfolio doesn't give you enough expected return, take advantage of it (within reason). If the risk is too much, take advantage of it. , deleveraging with cash. Surprisingly, this has proven to be effective.”
Asness goes back to the basics of modern portfolio theory and suggests that you can own a single asset, but that single asset is a portfolio of assets that is diversified (i.e., completely uncorrelated) on a risk-adjusted basis. This indicates that you should not expect to outperform the .
Is diversification important for cryptocurrencies?
Cryptocurrency investors should also ask themselves similar questions. Why not 100% Bitcoin?
Given the amount of media attention given to Bitcoin, market commentators still often equate “cryptocurrency” with “Bitcoin.” While the approval of a Spot Bitcoin ETF may be an important first step toward widespread investor adoption, notable deviations from the golden rule of diversification have surfaced.
Let's go back to 2018 and consider four crypto portfolios. A passively weighted portfolio of Bitcoin only and Ethereum only (no diversification), an equal weighted allocation to Bitcoin and Ethereum (slight diversification), and the top 10 non-stablecoin assets. Specific month (better variance).
The bottom line is that diversification is important for cryptocurrencies.
Bitcoin-only and Ethereum-only portfolios produced very similar annualized returns of around 30%, but Ethereum-only had higher volatility, resulting in lower risk-adjusted performance compared to Bitcoin. has worsened. Annual returns of this magnitude may satisfy “Bitcoin bulls” and “Ethereum maximalists,” but can investors build more efficient portfolios? Yes.
By combining Bitcoin and Ethereum into a simple equal-weighted basket of two assets, we see a significant increase in risk-adjusted returns. Compared to Bitcoin alone, there is a slight increase in annualized risk, but the increase in return is greater than the increase in volatility, resulting in better risk-adjusted performance. If the small increase in risk compared to Bitcoin alone is unacceptable to the investor, the investor can hold some cash alongside the portfolio and reduce volatility while achieving better returns. Masu.
Adding more assets to the portfolio further improved risk-adjusted returns. For a passively weighted monthly rebalanced portfolio of top 10 assets by cycling market capitalization, the annualized volatility remains essentially constant compared to the equal weighted BTC-ETH portfolio, and the annualized Returns have increased significantly.
Expanding the scope of digital assets to better capture the differentiated value proposition of blockchain technology has improved the portfolio's risk-adjusted return characteristics.
Despite the short and volatile history of cryptocurrencies, recent evidence suggests what traditional markets have repeatedly demonstrated. This means that owning a single asset provides poor risk-adjusted returns over the long term compared to a diversified portfolio of assets.
