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.
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 from a series of portfolios constructed from Bitcoin, Ether, Litecoin, and Ripple.
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.
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.
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.
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.
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.
How To Diversify Away Risk In A Crypto Portfolio: Correlation And Variance
Published on May 3, 2018
by Cointele | Published on Coinage
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