Three major portfolio principles and how they apply to crypto

Daniel McGlynn - Friday, December 14th, 2018

We recently published a paper about how adding small amounts of crypto to a traditional investment portfolio consisting of stocks and bonds can greatly help overall performance.

This is the second in of series of posts about the paper and its conclusions.

In the first post, we briefly outlined the biggest takeaway of the paper, which is that cryptocurrencies are a useful way to add the right kind of volatility to a portfolio.  The paper shows, this strategy can lead to better overall returns.

Understanding investing portfolio dynamics and how crypto applies

If nothing else, the recent crypto market downturn offers a chance to learn more about smart investing and the mechanics of building a sound portfolio over time.

“The new frontier” paper looks at a few different useful concepts that are useful for making sound portfolio decisions.

Correlation

Correlation is one of the key fundamental investing principles to understand.

Crypto is an emerging asset class. So far, it is a correlated asset class, meaning that when the price of bitcoin goes up, generally, the price of other cryptos also goes up. 

This graphic shows that cryptoassets are more alike when compared with other cryptoassets. For example, bitcoin’s correlation with other individual cryptoassets ranges from 0.15 to 0.62. This means that cryptoassets behave similarly in a market context, and supports the idea that cryptoassets fit together as a unique asset class.

When the price of bitcoin goes down, so too does the price of other cryptoassets. But, crypto remains uncorrelated to other traditional assets, which makes it a useful portfolio ingredient. In other words, fluctuations in prices of other assets do not affect the price of cryptoassets.

Cryptoassets are uncorrelated to traditional assets
This chart shows that bitcoin (which behaves like other correlated cryptos in the chart above) is uncorrelated to traditional assets. This is significant because a balanced portfolio should consist of various kinds of assets that will behave differently under market conditions.

Sharpe ratio

Another investing concept discussed in “The new frontier” paper is the Sharpe ratio concept.

Not all investments perform the same. Some are risky but might offer high returns, others are might be less risky, but might have a low rate of return. The Sharpe ratio is a method of adjusting risk so that it’s easier to compare different kinds of assets to one another. Crypto generally have a higher Sharpe ratio when compared to stocks and bonds, which means they can provide an overall benefit to investment portfolios looking to take on risk in search of returns.

This graphic shows how the Sharpe ratio can be used to compare risk-adjusted cryptoasset performance.

Efficient frontier

Efficient frontier: The efficient frontier is a concept used to examine how well the balance between risk and reward is working within a portfolio. The efficient frontier is a conceptual tool to compare the returns and volatility of different portfolios and is often visualized in a graph.

Despite high volatility, and when taking into account risk-adjusted performance, adding cryptoassets to a traditional portfolio pushes the efficient frontier up and to the right, which is a positive outcome when considering how to add the right kind of risk to investment holdings.

Key takeaways

Since cryptocurrencies are still a maturing asset class, they aren’t often thought of as having a place in a traditional investment portfolio. But, the research in “The new frontier” paper shows, that there is a potential benefit to adding cryptoassets as a way to diversify.

The paper goes into more depth about different investment risk scenarios and portfolio constraints.

As a reminder: Any content contained in this blog post is provided for informational purposes only and is not intended as financial or investment advice.