The Reasons Why Diversification Is Important for Cryptocurrency

Established and widely recognized financial theory demonstrates that diversification is beneficial and enhances expected returns relative to risk. Regrettably, the cryptocurrency industry appears to be neglecting this fundamental concept.

Comparable to the Term “TradFi”

A statistical investment management firm called AQR recently published a post that draws a direct parallel to the problem of under-diversification in conventional finance. Cliff Asness, co-owner and chief investment officer of AQR, writes a new article that questions the wisdom of investing only in stocks, an attitude that crops up again during bull markets.

The blog discusses various principles of fundamental financial theory, which essentially state that it is not ideal to possess only one asset:

In Finance 101, we learn the importance of distinguishing between two key considerations: firstly, determining the optimal portfolio that offers the highest return relative to risk, and secondly, identifying the level of risk we are willing to assume. This fresh article, along with numerous others, mixes up the two.

If the portfolio with the highest risk-adjusted return does not meet your desired level of expected return, then consider leveraging it (within reasonable limits). If the level of risk is a concern, you can reduce it by using cash. This has been demonstrated to be highly effective.

While it is theoretically feasible to own a single asset, Asness argues that more than this would be needed to justify the expense of maintaining a diversified portfolio when considering risk-adjusted performance.

What Role Does Diversification Play in Cryptocurrency?

Why not go all-in on Bitcoin? Crypto investors should consider this question.

A significant number of market commentators continue to associate the term “crypto” exclusively with Bitcoin. This is because Bitcoin receives extensive coverage in the media. The acceptance of immediate bitcoin exchange-traded funds (ETFs) may mark a significant initial step towards widespread investor adoption; however, it has become apparent that there has been a noticeable deviation from the fundamental principle of diversification.

Here are hypothetical cryptocurrency portfolios from 2018 that we can look at: one that is Bitcoin and Ethereum only (no diversification), one that is Bitcoin and Ethereum weighted equally (some diversification), and one that passively weights the top ten non-stablecoin items monthly (enhanced diversification).

Ultimately, having a diverse portfolio is crucial when it comes to cryptocurrencies.

The portfolios consisting solely of Bitcoin and Ethereum generated remarkably similar annualized returns of approximately 30%. However, Ethereum only displayed greater volatility, leading to inferior risk-adjusted performance compared to Bitcoin. Such impressive annual returns might appease enthusiasts of Bitcoin and Ethereum, but is there room for investors to build more optimized portfolios? Absolutely.

Through the amalgamation of Bitcoin and Ethereum in a straightforward, equally balanced collection of these two assets, we witness significantly enhanced returns that take into account the level of risk involved.

When comparing it to Bitcoin only, the annualized risk does go up a bit. Still, the increase in return outweighs the rise in volatility, leading to a better risk-adjusted performance. If the investor finds the slight rise in risk compared to Bitcoin Only unacceptable, they can choose to hold some cash in addition to their portfolio. This will help reduce volatility while still allowing them to achieve higher returns.

Expanding the range of assets in the portfolio further enhanced risk-adjusted returns. By utilizing a portfolio that is passively weighted and rebalanced on a monthly basis, the annualized volatility of the portfolio remained consistent compared to the BTC-ETH portfolio, which is equally weighted. However, there was a significant increase in annualized returns.

Expanding the range of digital assets to capture the unique benefits of various blockchain technologies effectively enhanced the portfolio’s risk-adjusted returns.

Conclusion

When compared to a diversified portfolio of investments, holding a single asset tends to yield lower risk-adjusted returns over the long term. This is a pattern that has been consistently observed in traditional markets. In light of the relatively short and unpredictable history of cryptocurrency, emerging data indicates that this pattern has been observed.