How to Diversify Away Risk in a Crypto Portfolio: Correlation and Variance
Diversifying away risk in a cryptocurrency portfolio could be very difficult, however, research shows us otherwise.
Disclaimer: This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.
Observations of the crypto market give impression that “when Bitcoin sneezes, the cryptocurrency market catches a cold”, – in traditional stock markets this would not be the case. Although there are public companies whose stock movements have strong correlations due to those doing similar work in the same industry - oil companies, for example - investors are still capable of diversifying away risk in an equally weighted portfolio by adding stocks with negative correlations to the portfolio.
Technically, diversifying away risk in a crypto-only portfolio could be difficult. Creating a two-asset portfolio with highly correlated stocks gives an investor a greater risk of losing more wealth. When two assets have a strong correlation coefficient they tend to move in the same direction. If two assets in the same portfolio move in the same direction then your gains in wealth will be greater and your losses more severe. That could be the reason why investors try to create portfolios with negatively correlated stocks.
If one asset is declining in a portfolio consisting of two assets that are negatively correlated, then the other asset in the portfolio should be increasing. This should in effect diminish the maximum amount of wealth that can be lost in a portfolio.
Just from checking out the digital asset prices on a cryptocurrency exchange, one can see that they are highly correlated with one another. If Bitcoin is in the red for the day, nearly every cryptocurrency on the homepage will be in the red, if Bitcoin is in the green, – so would be the others. That is why people say that “even the most unseaworthy boats will float when the tide rises”.
Correlation of cryptocurrencies
Economic researcher Vasily Sumanov told Cointelegraph the cryptocurrency market is highly correlated because most altcoins are bonded to Bitcoin:
“The market is very small [market cap] and has low-liquidity, a majority of the trade volume is provided by algorithmic traders using bots. There are only a few exchanges who actually establish prices but prices at these exchanges are connected to arbitrage bots also. All digital assets are really bonded to the BTC market - besides stable coins like USDT - so every change in the market is immediately mimicked by other assets.
When BTC/USD is falling, all digital assets/USD are falling because the price of a majority of digital assets is being calculated via the USD/BTC price. For example, when BTC is falling, traders could sell altcoins for BTC. Afterward they could immediately sell Bitcoin, and receive dollars and then buy back their BTC at a lower price. Then they could buy cheap altcoins with their Bitcoin.”
It could be well illustrated by this winter fall of the crypto market. Here is what it looked like, for example, on Feb. 2, 2018. While Bitcoin lost 15%, Ripple lost 30% – XRP could have become cheaper due to the algorithm used by a majority of traders.
Image source: Coinmarketcap
In a correlation matrix created from the yearly returns of Bitcoin (BTC), Ethereum (ETH), Litecoin (LTC), and Ripple (XRP), there are seven out of ten digital asset pairs that are perfectly correlated; BTC-BTC, BTC-ETH, ETH-ETH, ETH-LTC, ETH-XRP, LTC-LTC, and XRP-XRP. The three other pairs still show strong correlation – anywhere between .7 and 1: BTC-LTC is correlated at .934, BTC-XRP at .729, and LTC-XRP at .892.
Trading systems technology and operations consultant Tony Karim shared with Cointelegraph his opinion that digital assets are highly correlated due to investor sentiments and systematic risks:
“Mainstream crypto assets (not so much with newer altcoins) are closely correlated in their volatility due to the same catchment of underlying investors who are almost exclusively sentiment driven with similar trading motives without reviewing any of the drivers and flow of this market.”
“The recent devaluation has been due to fundamental activities and pressure be it regulators, thefts from exchanges and individuals, and other negative publicity. Therefore, when one crypto asset is impacted, this propagates to completely different cryptos using totally different technology on a bear or bull trend on the mainstream assets by market volume. Another fact is liquidity is in the hands of a few and based on the total number of crypto assets actively trading daily vs the number in circulation. There isn’t the same sense of liquidity that is present in other markets.”
If crypto-assets fall victim to high correlation coefficients, would it be possible to diversify away risk in an equally weighted cryptocurrency portfolio by adding more crypto-assets? To answer this question we will analyse the expected returns and standard deviations (SD) from a series of portfolios constructed from Bitcoin, Ether, Litecoin, and Ripple. All the data analyzed consists of yearly prices taken on Oct. 5, as the first day for the earliest year available.
Single asset portfolios
Bitcoin’s blockchain was launched on Jan. 3, 2009. Based on the yearly returns from 2010 to 2017, with a portfolio that consists of only Bitcoin, you can expect a 194.2 percent return on average. The standard deviation - the amount you can expect the returns to deviate from the average - associated with holding a portfolio of only Bitcoin is 168.8 percent. This means that the returns you can expect from Bitcoin could deviate 168.8 percent above or below the average return.
Ethereum was released on July 30, 2015 as a blockchain network that allows companies to create applications, contracts, or systems via programming on the Ethereum network. The data for Bitcoin and Ethereum in this article was pulled from 99Bitcoins.
If you hold a portfolio that consists of only Ethereum, you can expect a 307.29 percent return based on Ether’s yearly return data from 2015 to 2017. The standard deviation of an Ethereum only portfolio is 6.06 percent. This means that one can expect the yearly returns of Ethereum to be rather reliable and not stray too far from the average return of 307.29 percent. That being said, Ethereum has only existed for 3 years.
Litecoin was released on Oct. 7, 2011, created from a fork in the Bitcoin Core blockchain. For that reason, Litecoin is very similar to Bitcoin, and that may be why Litecoin does not have its own white paper. Litecoin aims to solve some of the problems associated with Bitcoin such as network efficiency and transaction verification speed. The data for Litecoin in this article was pulled from Bitinfocharts.
Based on the yearly returns of Litecoin from 2013 to 2017, if you hold a Litecoin-only portfolio, you can expect a return of 136.1 percent with a standard deviation of about 163.6 percent.
Ripple was released in 2012 as a cryptocurrency and global remittance service for banks to make nearly instantaneous cross border payments for an amount lower than traditional transaction fees. The data for Ripple in this article was pulled from Coinmarketcap.
Based on the yearly returns from 2014 to 2017, with a portfolio that only consists of Ripple, you can expect a 80.3 percent return on investment. A Ripple-only portfolio has a standard deviation of about 182.5 percent.
Two asset portfolio
In a two asset portfolio the expected returns will increase in respect to every single-asset portfolio except when comparing the Litecoin-only portfolio to the LTC-XRP portfolio, the Bitcoin-only portfolio to the BTC-LTC and BTC-XRP pairs, and the Ethereum-only portfolio to the ETH-LTC, ETH-XRP, and ETH-BTC pair.
The expected return is the average of the returns from previous years. Because Bitcoin and Ethereum have relatively high expected returns in their single-asset portfolios, when you add either XRP or LTC to the Bitcoin or Ethereum-only portfolios, the lower expected return values of LTC and XRP drag down the overall expected return of the portfolio. For example: 2>1, 1+2=3, 3/2 = 1.5, 1.5 < 2.
That is why the expected returns are lower for every two asset portfolio containing BTC, besides the BTC-ETH pair. In the BTC-ETH portfolio, Ethereum’s average return is higher than Bitcoin’s average return; so when the portfolio’s expected return is averaged, the expected return for the two-asset portfolio is higher than the expected return for the BTC-only portfolio - for example 2 >1, 1+2 =3, 3/2 =1.5, 1.5>1.
The standard deviation associated with a portfolio consisting of two assets is lower than the SD of every single asset portfolio (except when comparing the Ethereum-only portfolio to every other one containing Ethereum or the Litecoin-only portfolio to the LTC-XRP one).
The standard deviation of Ethereum is so low (6.05 percent) that when another asset is added to an Ether-only portfolio, the higher SD of the other asset raises that of the entire portfolio to a level higher than that of an Ethereum-only portfolio.
In the LTC-XRP portfolio, the standard deviation of the portfolio is 4.77 percent higher than SD of a Litecoin-only portfolio (163.6 percent). For most investors, this may be nothing to sneeze at, but it all depends on the level of risk that an investor is able to tolerate.
Three asset portfolio
In a three-asset crypto portfolio, the expected returns increase in comparison to every-two asset portfolio.
The standard deviation associated with holding a three-asset crypto portfolio will increase in comparison to every two-asset portfolio except those with LTC-XRP, BTC-XRP, and BTC-LTC, their SD will decrease when you add a third crypto-asset to the portfolio.
Four asset portfolio
In an equally weighted crypto portfolio that consists of BTC, ETH, LTC, and XRP the expected returns would decrease compared to those of every three-asset portfolio. The maximum decrease in expected return is 232.225 percent and comes from the portfolio that adds Bitcoin to the ETH, LTC, XRP portfolio, and the minimum decrease in expected return is 119.159 percent and comes from the portfolio that adds ETH to the BTC, LTC, XRP portfolio.
The standard deviation would increase in respect to three out of the four three-asset portfolios, with the only decrease in the SD being in reference to the BTC, LTC, XRP portfolio by 4.91 percent.
So how to diversify away risk in crypto portfolios?
Although digital assets are highly correlated, it is possible to diversify away risk in a crypto-only portfolio by adding more crypto assets to the portfolio. It is possible to diminish standard deviation when you move from a single-asset portfolio to a two-asset portfolio in 3 out of the 6 possible two-asset portfolios; from a two-asset portfolio to a three-asset portfolio – in respect to 3 out of 6 two-asset portfolios, and in a four-asset portfolio – in respect to 1 of the 4 three-asset portfolios.
The reason you are able to diversify away risk in a crypto-only portfolio even though the crypto-assets are highly correlated could be because there are different types of risk, as Sumanov said to Cointelegraph.
“Diversification in a crypto-only portfolio can help with the following:
- Single asset risks. Risks of project failing, delisting from exchanges, ban from government, problems with team etc. Huge dump due to a major holder deciding to sell all his holdings one day and many other risks, that are connected with holding only a single asset. For example, TenX token (ticker PAY) declined a lot in price after Wirex Company declined their contract for cryptocurrency card issuing due to EU regulator.
- Connection of portfolio value to average industry growing. If you invest in just single or few assets, it is like playing the lottery. Your assets can perform differently – one could grow fast, and another could just make +10 percent and that is all. So, portfolio diversification gives you the opportunity to receive profit from the whole market growing and not depend just on having faith in one coin.
- You can make different portfolios (for example high-risk, average, low risk) and receive profit that will be “averaged” on risk type.”
Even though digital assets are highly correlated, it is possible to mitigate the amount of risk you are exposed to by investing in multiple crypto assets instead of only one crypto-asset. This is reminiscent of the old adage “you should not put all your eggs in one basket”. By investing in multiple crypto-assets it is possible to spread out the amount of risk you are exposed to instead of having all of the volatility of the portfolio come from one asset. By spreading the risk over several assets, it could be also possible to increase the expected returns of a portfolio while diminishing the amount of standard deviation of the portfolio.
When comparing all six two-asset portfolios to the four single asset portfolios, it is possible to increase expected returns in respect to at least one of the single-asset portfolio. Comparing the three-asset portfolios to the two asset portfolios, it is possible to increase expected returns in all four three-asset portfolios, and when comparing a four-asset portfolio to the three-asset portfolios, it seems not possible to increase expected returns in comparison to the three-asset portfolios.
The analysis shows that spreading wealth over a number of assets, instead of putting all into one, could diversify away the idiosyncratic risk that is unique to a particular digital asset, and the more risk one is able to diversify away, the better situated he could be to protect himself against losses in the cryptocurrency portfolio.
The views expressed here are the author’s own and do not necessarily represent the views of Cointelegraph.com