Any investment involves risks, especially investing in cryptocurrencies, since their market value is more unpredictable compared to traditional assets. Cryptoinvestors make up portfolios to protect themselves from high risks. They invest not in one cryptocurrency, but in several. This method, called diversification, reduces risks and partially protects investments if one asset falls, the investor does not lose everything due to the presence of others. However, it must be periodically rebalanced in order for a diversified portfolio to fulfill its functions. Below we analyze what the rebalancing of the cryptocurrency portfolio is and why it should be carried out!
What is cryptocurrency portfolio rebalancing?
Investor buys more than one cryptocurrency to diversify risks. He buys, for example, five cryptocurrencies – each for $ 200. The share of each cryptocurrency in his portfolio is 20%. The distribution can be any other not 20/20/20/20/20, but 30/30/20/10, currencies can be not 5, but 3 or 8, and so on.
Cryptocurrencies are chosen so as to optimize the combination of profitability and risks. For example, a highly profitable, but very volatile or unreliable currency for other reasons is balanced by a more stable one. When the first grows, the investor receives the main income from it, and when it falls, the income is already brought to him by a stable currency.
The problem is that cryptocurrencies are falling and growing constantly, as a result of which their share in the portfolio is also constantly fluctuating. A month after making a portfolio of 5 currencies of 20% each balance can change dramatically one currency will grow and will be no longer 20%, but 40%, and the other will fall and instead of 20% will be 5%.
The sense of diversification in the event of such an imbalance is lost, since the mentioned optimal combination of profitability and risks is violated. So, when the cryptocurrency grows, the investor will lose part of the possible income and sometimes the invested money.
For example, if the share of a currency that has fallen by 2 times is 20%, then the investor loses only 10% of the funds, and if the share of the same currency is 40%, then he loses 20% of the funds. In order to avoid these losses, rebalancing is carried out – restoring the optimal balance of cryptocurrencies in the portfolio.
Rebalancing the cryptocurrency portfolio: how to spend
The rebalancing of the cryptocurrency portfolio is concluded in that the investor sells or re-purchases the selected assets in the quantity necessary to bring their balance in the portfolio to the original one.
If one cryptocurrency has grown and is in the portfolio instead of 20% – 40%, and the second has fallen and is not 20%, but 5%, then it should get rid of half of the first cryptocurrency and buy the second one.
Rebalancing a cryptocurrency portfolio: results
The result of the rebalancing performed on time is getting a profit, since a timely response to the imbalance in the portfolio allows you to buy assets at a price decline and sell at peak.
The asset in the above example is bought when it fell to 5% in the portfolio, when its market value has decreased. Another asset is sold accordingly when its market value has increased. The cost will continue to fluctuate.
The increased asset, on the contrary, will fall. Therefore, its share in the portfolio will become too small and will need to be purchased. Then they will rise again and fall and the investor, after each sale of the grown asset that was bought while reducing the share in the portfolio, during the price decline, will receive a profit.
In addition, with timely rebalancing, the investor’s portfolio will always be diversified, which is important on the cryptocurrency market, since the fall in assets can be significant, sharp and rather unexpected.
When to rebalance the cryptocurrency portfolio?
There are a number of more or less general patterns that should be taken into account when answering the question about the frequency and timeliness of rebalancing a cryptocurrency portfolio.
Rebalancing brings profit to the investor only if the assets in the portfolio have a slight correlation or if there is none at all. This means that they should not depend on each other.
This condition is poorly fulfilled on a crypto market, since cryptocurrencies are highly correlated with each other initially. The course of some coins changes without regard to others in certain cases.
However, often the market falls or grows as a common. Unpopular currencies are highly dependent on the rate of the leading ones and if Bitcoin drops noticeably, the entire market falls, and if Bitcoin grows, then everything else grows.
On the one hand, the portfolio on this background remains balanced. On the other hand, with simultaneous and similar fluctuations in the exchange rate, the rebalancing of the cryptocurrency portfolio will not bring any income to the investor.
As the market grows, the investor makes a profit due to the growth of all assets at the same time as Fiat and ultimately does not need to be rebalanced as a method of providing income and reducing risks. However, when the market falls, the investor loses income.
Rebalancing could help if some of the assets in the portfolio did not depend on the crypto market and did not correlate with it on the resulting “surplus” of these assets, it would be possible to purchase fallen cryptocurrencies. With a high correlation of all assets, it turns out that there is nothing to buy fallen assets, since there is no “surplus”.
This pitfall can be circumvented by adding either fiat currencies or other traditional assets to the portfolio or keeping a currency that shows particular stability in market fluctuations in the portfolio, for example, tied to the dollar, gold, and so on.
Also, rebalancing can play a cruel joke with an investor when an asset disappears from the market. Suppose one of the assets in the portfolio falls. The investor conducts rebalancing, that is, it purchases it. The asset continues to fall. New investors often rebalance again and re-buy it.
As a result, a complete collapse of the asset’s rate can occur without hope of recovery and the investor loses the money invested, including during the rebalancing process.
This reef is also quite easy to manage with a noticeable drop in the asset’s rate, before rebalancing is carried out, it is worth analyzing it. If further growth after the fall is likely, then rebalancing the portfolio is advisable.
However, if it is not clear how the cryptocurrency will behave in the future, if there are rumors about its excessive unreliability, then it is worth holding off the rebalancing. Alternatively, add another cryptocurrency to the portfolio.
Also, portfolio rebalancing only makes sense if the overall trend of all assets is positive or at least not negative. That is, if an investor fails to choose cryptocurrencies and invests in three cryptocurrencies that will fall, albeit at different speeds, rebalancing will not save him.
Should I rebalance the cryptocurrency portfolio?
An investor with a portfolio of five top cryptocurrencies, when rebalancing is carried out after each change in the asset share by more than 10%, can expect at least 40% profit per month, on average – 60-70%.
Buying one prospective crypto asset in some months leads to the same indicators, in some – to lower ones. A non-rebalanced cryptocurrency portfolio almost always leads to lower rates, which are at best 2/3, and at worst – less than 1/3 of the return compared to the rebalanced portfolio.
Therefore, it is certainly worth investing a cryptocurrency portfolio rebalancing. This practice is widespread when investing in traditional assets.
According to statistics, for 2-4 years without rebalancing in the portfolio consisting of traditional assets, the share of high-risk comes to 80–90% and the risk of bankruptcy due to the fall of such assets increases by 70–85%.
The development of events in the cryptocurrency market is similar with the only difference that everything happens on it several times faster. For a high-risk cryptocurrency share to exceed the stable cryptocurrency share so much, a few months will suffice, and with strong market fluctuations, a few weeks.
The investor will not receive the money that could have been earned with timely rebalancing by ignoring what is happening, at worst case he will lose some of the investment. Finally, it is worth to remember that the optimal balance of assets in a portfolio is called not for nothing the best and maintaining it is naturally the most optimal tactic.