21 min readAs demand for crypto grows, investors are adopting many of the techniques used to manage portfolios holding traditional asset classes.
One of these techniques is risk management, which aims to preserve capital and prevent emotions from influencing investment decisions. Asset allocation is a key risk management strategy, but from time to time individual holdings may outperform and skew the weightings. If this happens, the portfolio needs to be rebalanced, which means returning it to its original allocation.
Risk management particularly matters when investing in volatile asset classes, so this article explores crypto’s role in a balanced portfolio and how rebalancing works.
Understanding Crypto Market Volatility
Crypto is among the most volatile asset classes, as demonstrated by the frequency of peaks and troughs in the chart below.
A number of factors drive these price fluctuations:
Market sentiment - Crypto is subject to the whims of investors who allow emotions like fear or greed to influence their decisions. These emotions are often triggered by media hype or social media noise.
Regulatory developments - As a relatively immature asset class, rules governing the crypto markets are inconsistent and constantly evolving, which puts off some investors. But regulatory clarity can work both ways (as explained below).
Tech advances - As a digital currency, advances in the underlying infrastructure and threats to it can affect market sentiment.
Macroeconomic events - Investors increasingly treat bitcoin as a store of value when faced with economic or political uncertainty and a hedge against inflation. Some even refer to it as ‘digital gold’.
Correlation - BTC/USD is the most common trading pair, so bitcoin weakens when the US dollar strengthens and vice versa.
A good example of regulatory clarity causing outflows is when China stopped financial institutions and payment providers from processing crypto transactions in May 2021, sending bitcoin down by 30% in the space of a day. China then banned all crypto trading and mining four months later, which was significant because it hosted 70% of the world’s mining activities. Bitcoin dropped more than 9% in response.
The factors listed above can also act as catalysts. Roughly every four years, the rewards earned by miners (who complete complex mathematical puzzles to validate transactions) halve as part of a mechanism designed to support the scarcity of bitcoin (the total circulation is limited to 21 million). The last ‘halving’ had been priced in when it occurred in May 2020, as bitcoin rose from just over $5,000 to more than $9,500 in the preceding three months.
The Basics of Asset Allocation
When constructing a portfolio, investors use a strategy known as asset allocation to ensure their holdings match their goals and risk appetite. In traditional markets, this process typically involves splitting capital between equities and bonds, although other asset classes may feature such as cash or alternatives like property and commodities.
The main benefit of asset allocation is it ensures a portfolio is diversified. Equities and bonds are uncorrelated (they move in different directions), so underperformance by one offsets outperformance by another. A diversified portfolio tends to deliver more consistent returns.
Committing to an allocation also encourages investors to take a long-term view because they’re less likely to make decisions based on emotions.
Crypto’s Role in a Portfolio
Bitcoin is becoming increasingly popular in investment portfolios because it isn’t correlated with traditional asset classes.
To measure bitcoin’s impact on returns, CoinShares tracks the monthly performances of three sample portfolios:
A standard allocation of 60% equities and 40% bonds
A standard allocation with 4% gold
A standard allocation with 4% bitcoin
A standard allocation with 4% bitcoin which isn’t rebalanced
The first three portfolios are rebalanced every quarter.
The table below shows the latest results (as of 8th August 2023):
While the unbalanced bitcoin portfolio delivered the strongest returns, it also experienced the biggest drawdown and the greatest volatility. So the balanced bitcoin portfolio was most efficient, demonstrating the importance of returning to the original allocation when weightings get skewed. Bear in mind, this isn’t investment advice. As mentioned earlier, every investor should choose an asset allocation that matches their goals and risk profile.
Investors can use several other metrics to track performance in addition to those featured in the analysis above:
The Sharpe ratio measures the risk-adjusted return of a portfolio by charting performance against the return on an asset that is considered risk-free, such as a US treasury.
Market Value to Realised Value compares the current price against the volume-weighted sum of all previous prices.
A moving average measures the average price of an asset over a given interval.
The Relative Strength Indicator compares average price gains with average losses over a given interval.
Learn more about these metrics and how to monitor your crypto portfolio.
The Basics of Portfolio Rebalancing
Investors can employ various strategies to manage risk, such as diversification and dollar cost averaging. Another worth implementing is rebalancing.
When one particular asset or class outperforms for an extended period, it skews the weighting of a portfolio’s holdings. Rebalancing restores the original asset allocation.
For example, take a standard allocation of 60% equities and 40% bonds. If equities outperform and their weighting rises to 70%, the portfolio’s overall risk exposure increases (as equities are more volatile than bonds). In this case, the investor would sell equities until the weighting returns to 60%.
Rebalancing also takes place when a change of goals needs to be reflected in the portfolio’s risk exposure. If the time horizon extends, the investor can afford to hold a higher proportion of equities because they have longer to ride out market fluctuations.
There are two key approaches to rebalancing:
Calendar-based occurs at a certain frequency, usually yearly but also quarterly or even monthly.
Threshold-based happens when a portfolio diverges from its original asset allocation by a specific percentage. This approach involves close monitoring of performance, sometimes daily, which isn’t always practical for retail investors.
Regular rebalancing (either too frequently or using a small divergence) incurs higher transaction costs, so a hybrid approach may prove most efficient - check the portfolio on a set schedule and adjust the holdings if it has deviated from its original allocation by a predetermined percentage.
Of course, rebalancing a portfolio with crypto can be complex due to its relative inaccessibility compared with traditional asset classes. To hold crypto, investors typically need to purchase it through an exchange which may be unregulated or underregulated and then find a secure way to store it. However, they can also gain exposure through exchange-traded products (ETPs). ETPs are passive investments traded on mainstream exchanges that sit in portfolios alongside traditional asset classes.
Conclusion
Risk management is important when investing in volatile assets like crypto because it helps to preserve capital and takes the emotion out of decisions.
Rebalancing is a risk management strategy which restores a portfolio to its original asset allocation. The main benefit of maintaining a balanced portfolio is it ensures diversification across asset classes and delivers more consistent returns.
Demand for crypto has increased because it’s uncorrelated with traditional investments. Research by CoinShares suggests a portfolio with exposure to bitcoin is more efficient than a standard allocation or exposure to gold. That said, investors should allocate assets according to their goals and risk profile.
To add crypto to your portfolio, learn about the CoinShares Physical Crypto ETPs.