How to build a resilient portfolio for sustained growth

Region: Europe
Jan 11, 2024, 11:41:27 AM Published By Yves Renno

The cryptocurrency class resides within the high risk/high reward spectrum. Reflecting this risk category, the top 10 cryptocurrencies by market capitalization are undergoing constant evolution as projects frequently rise and fail to meet expectations.

Given this ever-changing landscape, relying on a simplistic buy and hold strategy on the top 10 cryptocurrencies wouldn’t yield sustained year-on-year growth. Regularly rebalancing our positions becomes imperative. Still, notable challenges persist:

  • The diversification value among the top 10 cryptocurrencies is questionable. Indeed, cryptocurrency returns typically exhibit high correlation above 70% (excluding stablecoins and trackers). If cryptocurrencies were perfectly correlated, the process of selecting and diversifying across various cryptocurrencies would lose its significance.
  • The predominant risk factor to mitigate is most often the global risk of the cryptocurrency class itself. This risk can only be mitigated by capping its allocation share within a multi-class portfolio.

I. Diversification and Stability

A. Importance of diversification

The objective of diversification is to mitigate specific risks. Consider, for instance, the risk of a sole investment in LUNA before the crash of May 2022, the risk of a single position in the FTX exchange utility token (FTT), or any cryptocurrency held by the FTX (e.g., SOL) before its collapse. If a recovery post-collapse is possible through either bankruptcy proceedings or a revived demand, it could still take years. Putting all our eggs in one basket is risky. This is why diversification makes sense.

In equity markets, specific risks could be somewhat mitigated through investments in broad market-cap weighted indexes like the S&P500. Unfortunately, there is no widely accepted index standard in cryptocurrencies. Even though market-cap weighted indexes do exist, they are still nascent and supported by few centralized entities.

B. Balancing high-risk and stable assets

One solution to mitigate cryptocurrency class risk (the cryptocurrency macro risk) is to allocate a portion of the portfolio to lower-risk stablecoins or relatively stable traditional assets trackers (e.g. PAXG tracking Gold and available on the Wirexapp).

In that sense, the surge of tokenization for securities and Real-World Assets (RWA) will facilitate this process. Tokenization consists of creating the digital representation of an asset. According to the erc3643 website, the ERC-3643 Standard aka T-Rex protocol, introduces a ‘decentralized identity framework‘ to ‘ensure that only users meeting pre-defined conditions can become token holders. In essence, rules defined for both investors and issuers/sellers must be met to trigger a compliant transfer.

Tokenization would eventually let a user build a digital portfolio diversified across multiple asset classes. Until then, the most widely used digital tokens at our disposal are the risky cryptocurrencies and the safer stablecoins. Rebalancing between both should be considered in light of the user’s risk target, market risk metrics and other specific patterns:

  • looking at the users’ risk profiles, the higher their risk tolerance, the larger their allocation towards risky cryptocurrencies.
  • relevant cryptocurrency macro factors should also be considered including market cycles.

There are four stages in a cycle:

  • accumulation: characterized by low prices. This is when HODLers increase their positions. Speculators and market makers have low activity. This phase can last two years. => Reallocate towards cryptocurrencies in line with the target risk profile. HODL.
  • markup / uptrend: our current phase. Bullish sentiment dominates as investors expect a market rally. this phase starts a few months before the Bitcoin halving event (e.g. April 2024) and can last up to a year and a half. => Hold or reallocate progressively towards stablecoins to keep the portfolio risk in line with the target risk profile
  • distribution / profit taking. Near the market peak, when the speculation level is at its highest, the sentiment starts shifting, and investors start taking profit. => Reallocate to stablecoins
  • markdown / downtrend. A panic sell movement can wipe out more than 80% of the market value from peak. => Hold stablecoins

II. Risk-Adjusted Returns and Rebalancing

A. Risk measurement and Optimization concepts Understanding risk-adjusted returns is crucial.

First, the concept of risk is typically measured by volatility, technically defined as the standard deviation of logarithmic returns. The higher an asset’s volatility, the higher its market risk. Volatility can be categorized as 'historic' when it is backward-looking and 'implied' when it is forward-looking, based on market expectations.

Examining the implied volatility of Bitcoin, the 30-day figure is nearly 70%. In comparison, although methodologies differ, the VIX index, which measures the 30-day implied volatility of the S&P500, is currently at 13%.

Therefore, Bitcoin exhibits more than 5 times the volatility of the S&P500 index.

If an investor is willing to allocate 100% of her portfolio to the S&P500 Index, then the risk-equivalent ‘efficient’ Bitcoin allocation would be:

  • Portion allocated to Bitcoin: volatility (S&P500) / volatility (Bitcoin) = 1 / 5 = 20%
  • Portion allocated to Stablecoin: remaining 80%

Modern Portfolio Theory (MPT) provides the most common quantitative framework to determine an allocation based solely on concepts of expected returns, volatility and correlation.

But this framework is not necessarily the best:

Let’s add WBTC to the portfolio. WBTC is the ERC-20 equivalent of BTC that is naturally almost 100% correlated with BTC. MPT would suggest the following allocation:

  • Portion allocated to Bitcoin: 20% or 0%
  • Portion allocated to WBTC: 0% or 20%
  • Portion allocated to Stablecoin: remaining 80%

Alternative frameworks like the ‘maximum diversification‘ framework would propose instead:

  • Portion allocated to Bitcoin: 10%
  • Portion allocated to WBTC: 10%
  • Portion allocated to Stablecoin: remaining 80%

Seeking maximum diversification among the selected cryptocurrencies (e.g. 10% in WBTC and 10% in BTC) could be recommended to mitigate portfolio concentration.

B. Rebalancing to adapt to market changes

In the context of MPT, expected returns, volatilities, and correlations determine the target optimal portfolio allocation. These are dynamic metrics influenced by market conditions.

Cryptocurrency prices affect the current allocation. For instance, as cryptocurrency prices surge during the markup phase, the portfolio's allocation share to cryptocurrencies in dollars will also increase.

Rebalancing resets the current allocation to the target optimal allocation. In this case, the process involves selling a portion of the portfolio's risky cryptocurrencies in favour of stablecoins. In other words, investors take a portion of their profits.

But in the markup phase, taking profits too early and too often incurs an opportunity cost.

Let’s go through a simple example comparing two scenarios.

For a $2,000 allocation in BTC and an $8,000 allocation in USDT stablecoins, assuming a logarithmic performance of +25%, and one rebalancing:

1. Before rebalancing at +25%: the allocation is worth:

BTC: $2,568 = $2,000*exp(25%)

USDT: $8,000

2. After rebalancing at +25%: the allocation is worth:

BTC: $2,114 = 20%*($2,568 + $8,000)

USDT: $8,454 = 80%*($2,568 + $8,000)

TOTAL VALUE: $10,568

With Frequent rebalancing: 5 times at every 5% increase.

Repeat 5 times - every time the log-performance gains 5%:

  • Before rebalancing at +5%: the allocation is worth:

BTC: $2,103 = $2,000*exp(5%)

USDT: $8,000

  • After rebalancing at +5%: the allocation is worth:

BTC: $2,021 = 20%*($2,103 + $8,000)

USDT: $8,082 = 80%*($2,103 + $8,000)

  • After rebalancing five times:

BTC: $2,104

USDT: $8,418

TOTAL VALUE: $10,523

Frequent rebalancing incurs an opportunity loss of $10,568 - $10,523 = $45. Profits are reduced by $45 / $568 = 7.9% as a result.

As previously explained, it is important to consider relevant information, current and expected market conditions, before initiating the rebalancing process. Opting for updates driven by quantitative models rather than manual discretionary adjustments can streamline the decision-making process.

For instance, these models have the capacity to identify, with some probability, the shifts in market regimes to systematically adjust risk and return expectations.

Building a resilient portfolio ideally requires a systematic approach, or at the very least, a rigorous one—well-documented and constructive.

*The prices of Cryptoassets fluctuate, sometimes dramatically. The price of a Cryptoasset may move up or down and may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling Cryptoassets.

*The value of cryptoassets may fluctuate significantly over a short period of time. The volatile and unprecedented fluctuations in price may result in significant losses over a short period of time. Any Cryptoassets may decrease in value or lose all its value due to various factors including discovery of wrongful conduct, market manipulation, change to the nature or properties of the Cryptoasset, governmental or regulatory activity, legislative changes, suspension or cessation of support for a Cryptoasset s or other exchanges or service providers, public opinion, or other factors outside of our control. Technical advancements, as well as broader economic and political factors, may cause the value of Cryptoasset s to change significantly over a short period of time.

*The above content should not be taken as financial or investment advice. Please do your own research thoroughly when looking to invest in cryptocurrency. Subject to the T&Cs and Privacy Policy.