The Importance of Rebalancing When Investing in Crypto

In view of the growing demand for crypto, investors take over many of the techniques used for the management of portfolios with traditional asset classes.

One of these techniques is risk management that aims to maintain capital and prevent investment decisions from being influenced by emotions. The asset allocation is an important strategy of risk management, but occasionally individual stocks can develop better and distort weighting. In such a case, the portfolio must be weighted and restored its original allocation.

Risk management is particularly important if you invest in volatile asset classes. This article therefore examines what role cryptos play in a balanced portfolio and how rebalancing works.

Understand the volatility of the cryptoma market

Krypto is one of the most volatile asset classes, as the frequency of the maximum and lows shows in the following graphic.

These price fluctuations are determined by a number of factors:

• Market mood – crypto is subject to the moods of investors who can be influenced in their decisions of emotions such as fear or greed. These emotions are often triggered by media hypes or social media noise.

• Regulatory developments – since it is a comparatively immature type of asset, the regulations for the cryptoma markets are inconsistent and constant change, which some investors deter. But regulatory clarity can work in both directions (as explained below).

• Technical progress – since it is a digital currency, progress can influence the market mood in the underlying infrastructure and this regard.

• Macroeconomic events – Bitcoin is increasingly regarded by investors as a substitute for value in economic or political uncertainty and as a security against inflation. Some even refer to Bitcoin as “digital gold”.

• Correlation – BTC/USD is the most common retail couple, i.e. h. Bitcoin becomes weaker when the US dollar becomes stronger and vice versa.

We show a good example of drainage caused by regulatory clarity: In May 2021, China prohibited the financial institutions and payment providers the handling of crypto transactions, which is about Bitcoin within one day 30 % dropped. Four months later China banned the entire crypto trade and mining, which was important in that important one in the country 70 % of the global mining activities. The Bitcoin then fell by more than 9 %.

The factors mentioned above can also act as catalysts. About every four years, the premiums that the miners (the complex mathematical tasks solve to validate transactions) are halved as part of a mechanism that is supposed to ensure the scarcity of Bitcoin (the total circulation is limited to 21 million). The last halving (halving) was already priced in when it took place in May 2020 and Bitcoin increased from just over 5,000 to more than $ 9,500 in the previous three months.

The basics of wealth allocation

When compiling a portfolio, investors use a strategy known as wealth allocation (asset allocation) to ensure that their stocks are in line with their goals and their risk to risk. In traditional markets, this process usually includes a division of capital into stocks and bonds, although other asset classes such as cash or alternatives such as real estate and raw materials can also play a role.

The most important advantage of wealth allocation is that you guarantee a diversified portfolio. Shares and bonds are incorporated (they develop in different directions), so that a below -average performance compensates for the above -average performance of the other. A diversified portfolio usually provides a more stable return.

The definition of an allocation also encourages investors to look at a long -term view, since they will make their decisions less often based on emotions.

The role of crypto in a portfolio

Bitcoin becomes an increasingly popular option in investment portfolios because this crypto-asset does not correlate with the traditional asset classes.

In order to measure the influence of Bitcoin on the return, Coinshares follows the monthly performance of the following sample portfolios:

• A standard allocation consisting of 60 % stocks and 40 % bonds

• A standard allocation with 4 % gold

• A standard allocation with 4 % bitcoin

• A standard allocation with 4 % bitcoin, in which no rebalancing is carried out

The first three portfolios are weighted every quarter.

The following table shows the latest results (as of August 8, 2023):

The Bitcoin portfolio without rebalancing achieved the highest returns, but also recorded the largest drawdown and the highest volatility. The Bitcoin portfolio with rebalancing was most efficient, which shows how important it is to return to the original allocation when the weightings shift. Please note that this is not investment advice. As already mentioned, every investor should choose a wealth allocation that corresponds to his goals and risk profile.

In addition to the key figures mentioned in the analysis above, investors can also use others to monitor the performance:

• The Sharpe quotient measures the risk-adjusted return of a portfolio by comparing the performance with the return of a wealth value, such as a US state bond.

• The “Market Value to Realized Value” indicator compares the current course with the volume-weighted sum of all previous courses.

• A moving average measures the average price of an assets in a certain period of time.

• The relative strength indicator compares the average price gains with the average losses in a certain period of time.

Find out more about these metrics and how you can monitor your crypto portfolio.

The basics of portfolio rebalancing

Various strategies for risk management are available to investors, such as diversification and Average cost effect. Another sensible strategy is rebalancing.

If a certain asset or a certain investment class has an above -average performance over a longer period of time, the weighting of the portfolio stands is shifting. Rebalancing restores the original portfolio structure.

For example, we take a standard allocation that consists of 60 % stocks and 40 % bonds. If the shares develop better and their weighting increases to 70 %, the overall risk of the portfolio increases (since stocks are more volatile than bonds). In this case, the investor would sell shares until the weighting is again 60 %.

A rebalancing also takes place if a change in the goals is to be reflected in the risk exposure of the portfolio. If the time frame is extended, the investor can afford to keep a higher proportion of shares, as there is more time to survive market fluctuations.

There are two important approaches to rebalancing:

• Calendar -based: Such rebalancing is carried out at certain time intervals, normally annually, but can also be carried out quarterly or even monthly.

• Threshold -based: is used if a portfolio deviates from its original asset allocation by a certain percentage. This approach includes precise monitoring of performance, sometimes daily, which is not always feasible for small investors.

Regular rebalancing (either too often or with a low deviation) is associated with higher transaction costs, so that a hybrid approach may turn out to be the most efficient: the portfolio is checked according to a fixed schedule and the portfolio is adapted if the portfolio deviates from a previously set percentage from its original wealth allocation.

Of course, the rebalancing of a portfolio with crypto can be complex due to the relatively difficult accessibility compared to traditional asset classes. In order to keep crypto-assets, investors usually have to buy them about a possibly not or only inadequate regulated Exchange, and then find a safe way to store them. However, you can also get involved in stock market -traded products (ETPS). ETPS are passive systems that are traded on regular stock exchanges and can be accommodated in portfolios alongside traditional asset classes.

Conclusion

Risk management is important if you invest in volatile assets such as crypto because it helps to get capital and emotions from the decisions.

Rebalancing is a risk management strategy that restores the original asset allocation of a portfolio. The main advantage of a balanced portfolio is that it guarantees a diversification over different asset classes and ensures a more stable return.

The demand for crypto has increased because this form of assets does not correlate with traditional systems. Studies from CoinShares suggest that a portfolio with a bitcoin engagement is more efficient than a standard allocation or gold engagement. Nonetheless, investors should align their wealth allocation according to their goals and risk profile.

If you want to add crypto to your portfolio, you can do more about here Physically stored crypto ETPs from Coinhares experience.