Crypto assets are becoming more popular as investment vehicles, not only for individual traders but for hedge funds looking for manage risk. With equities, you can analyze the balance sheet and the information a company has made available.
But with crypto assets, all the fundamentals are publicly visible in the blockchain.
Cryptocurrencies are attractive to portfolio managers because they offer an asset class that has low correlation with stocks and bonds.
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This makes cryptocurrencies a valuable tool in the portfolio manager's mission of building a diversified portfolio across several asset classes.
While virtually all cryptocurrencies are correlated to some extent, you can build a portfolio entirely based on cryptocurrencies with the principles of portfolio theory to limit your risk.
Tips for Managing a Cryptocurrency Portfolio
Here are some tips for managing a portfolio of crypto assets.
Apply Portfolio Management Theory to Your Crypto Portfolio
Portfolio management theory holds that higher potential returns are associated with higher risk, and vice versa.
This means that the assets in a portfolio should be diversified.
By choosing assets that do not move together as tightly, the collective volatility of the portfolio is reduced because the assets will not all move in the same direction and magnitude.
Establish the Client's Risk Profile
A client's risk profile is determined by two factors:
- Risk tolerance
- Risk ability
Risk tolerance:
Risk tolerance is determined by the client's experience, sensitivity to loss, awareness of the risks involved, and the client's desire to follow market developments.
Risk awareness:
Risk awareness is characterized by the client's desire for greater profit potential in return for higher risk or a lower potential for profit in return for lower risk.
Some of this is determined by personality and some of it is dependent upon their sensitivity to loss.
If clients are perfectly content with losing all their money, they can be much more aggressive, for example.
Risk ability:
Risk ability is composed of a few factors.
How long are they looking to cash out the investment? What ratio of the assets is free vs. bound?
This is basically the sum of all factors that prevent the client from risking their capital.
What is the client's comfort level with cryptocurrencies? Do they regularly visit a cryptocurrency news site and see what's happening with their investment? If not, they may be skittish about risk if they don't have a grasp of the rhythms of cryptocurrency.
The consideration of these factors leads to a risk profile. This determines the risks that a client is willing to take and clarifies what type of investments can be considered for their portfolio.
Constructing a Crypto Portfolio
There are three subclasses of cryptocurrency:
- Money
- Infrastructure
- General-purpose.
Bitcoin, Litecoin, Bitcoin Cash and Dash are all money-class cryptocurrencies. These cryptos attempt to compete with fiat currencies.
Ethereum is the leading infrastructure cryptocurrency. Cryptocurrencies with smart contracts are found in this category.
These cryptocurrencies do more than provide a store of value. They provide a token that drives infrastructure.
Other examples of infrastructure cryptocurrencies include Lisk and IOTA.
General-purpose cryptocurrencies are those which do not fall into the categories above. Each subclass has a particular risk signature that can be considered when applying a client's risk portfolio.
The money subclass has the lowest return and the lowest volatility. The infrastructure subclass has moderate returns and moderate volatility.
The general-purpose subclass varies widely, but generally has a higher return and higher volatility.
Something to consider with this theory is the standard-bearer status of Bitcoin and Ethereum.
As leaders of the two major classes, they are often bought and sold at the same time.
There are times, therefore, when the correlation between Bitcoin and Ethereum is very high, due to the fact that they are the two most popular cryptocurrencies and traders often trade in both.
You can examine the correlations of other infrastructure class cryptocurrencies with Bitcoin, or other money class cryptocurrencies with Ethereum, to attempt to avoid this problem.
By spreading your portfolio across these three subclasses of cryptocurrency, you can limit their correlation with each other and better manage your risk.
Conclusion
Crypto assets are quickly gaining steam as investments, from mainstream financial institutions and individuals alike.
The same rules of portfolio management theory that apply to traditional assets can be applied to cryptocurrency assets to limit your risk.
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