Discover the practice of crypto rebalancing to maintain your initial asset allocation even amidst market fluctuations.
During your journey into the world of cryptocurrency investments, you’ve likely encountered stomach-churning volatility and sudden market dips. These are all part and parcel of the exciting yet somewhat unpredictable landscape. So, what’s the solution?
A crypto rebalancing strategy could assist you in preserving the original balance of your asset allocations and creating opportunities for modest gains. Let’s get to grips with crypto portfolio rebalancing, breaking down its mechanics, analyzing its pros and cons, and strategies.
What is crypto portfolio rebalancing?
At its core, rebalancing is the practice of consistently adjusting the assets in your cryptocurrency portfolio to maintain your original allocation criteria. It’s not about haphazard buying; instead, it’s a calculated approach to ensure your initial asset allocation strategy remains intact, even when the market experiences significant fluctuations.
Let’s illustrate this with an example. Imagine your portfolio is nearly evenly balanced, with Dogecoin (DOGE) valued at $40 and Polygon (MATIC) at $30. If you decide to invest an additional $30, a wise move would be to allocate $10 to DOGE and $20 to MATIC. This way, you maintain a 50/50 balance, with each asset totaling $50. But what happens when the market undergoes substantial shifts, causing your assets’ values to drift?
For instance, if your portfolio includes Bitcoin (BTC) valued at $200 and Ethereum (ETH) at $500, rebalancing would involve selling $150 worth of ETH and buying $150 of BTC. This rebalancing act resets your portfolio’s balance at the beginning of each investment period, effectively mitigating excessive risk.
How crypto rebalancing can boost gains?
Let’s examine the impact of different portfolio strategies and their returns and volatilities between January 2018 and September 2020:
|Portfolio||Total invested ($)||Total value ($)||Total return ($)||Total return percentage||Maximum drawdown (%)||portfolio volatility (%)|
If you had invested solely in BTC with an initial investment of $7,100, your portfolio would now be worth $11,922.70, resulting in a total return of 67.93%. However, this approach comes with higher risk, as evidenced by a maximum drawdown of -52.41% and a portfolio volatility of 6.45%.
On the other hand, an all-in investment in ETH yields the highest return at 116.79%, increasing your portfolio value to $15,392.11. However, this high return is accompanied by heightened risk, with a significant drawdown of -61.02% and a volatility percentage of 6.44%.
Now, let’s focus on a balanced approach, the 50/50 portfolio allocation. Without rebalancing, your portfolio would be valued at $13,657.40, with a total return of 92.36%. This strategy strikes a balance between return and risk.
But the real standout is the rebalanced 50/50 portfolio. With the same $7,100 investment, its value surges to $14,104.48, resulting in a total return of 98.65%. Although this strategy slightly increases the maximum drawdown to -56.83%, it maintains a moderate volatility level of 6.14%. Notably, rebalancing a 50/50 portfolio leads to an incremental gain of 6.29% compared to the non-rebalanced counterpart.
Advantages and disadvantages of portfolio rebalancing
Here are the pros and cons of portfolio rebalancing to help you make informed investment decisions:
- Risk mitigation: Continuous monitoring and adjustment of your portfolio limit potential losses, preventing any single asset from causing significant capital damage.
- Diversification: Rebalancing allows you to spread your capital across a broader range of assets, reducing risk exposure and potentially resulting in more stable returns over time.
- Emotion-free investing: Regular rebalancing ensures that emotional attachments to particular assets don’t sway your investment decisions. If an asset consistently fails to generate profits, it’s easier to make the rational decision to divest.
- Dynamic allocation: Rebalancing enables you to actively change allocations based on fundamental analysis, allowing you to capture interim gains, even if your primary focus is long-term investment.
- Dependent on market momentum: The primary strategy behind rebalancing relies on market momentum, which is not always predictable. High-performing assets may not necessarily decline in value, and low-performing investments may not always surge.
- Potential loss of opportunities: Rebalancing may force you to sell assets that continue to appreciate in value, potentially leading to missed opportunities for higher gains. Moreover, reinvesting in assets moving in the wrong direction could result in losses.
- Asset narratives and market trends: It is crucial to consider the broader market narratives and trends when rebalancing. Selling assets should ideally be based on fundamental changes or discrepancies in the asset’s development roadmap or network performance, not just price movements.
- Transaction costs and tax implications: Frequent rebalancing can incur significant transaction fees and potential tax liabilities, especially in jurisdictions with stringent tax regulations on crypto trades.
Crypto portfolio balancing strategies
Now, let’s explore potential portfolio balancing strategies, each with its distinct approach and factors to consider.
Threshold portfolio rebalancing
This strategy acts as a safeguard against the erratic behavior of crypto markets by imposing strict tolerance bands that limit asset fluctuations in your portfolio. It’s a highly reactive approach, with rebalancing decisions triggered by market dynamics reaching predefined thresholds.
You’ll need to set a clear threshold, serving as a triggering point for rebalancing. This threshold represents a percentage band that identifies significant rises or falls in asset values, helping mitigate extreme portfolio volatility. For instance, if your portfolio comprises equal proportions of XRP and BNB, you could set a 5% deviation as the maximum permissible split. This means that if a 55/45 split occurs, it triggers a rebalancing action, where you would sell some XRP to purchase BNB or vice versa to maintain portfolio equilibrium.
Narrower thresholds mean less volatility but more frequent rebalancing, leading to higher transaction costs. This approach can be wise when dealing with highly volatile crypto assets, as they are more likely to breach low thresholds. Conversely, wider thresholds reduce the chances of breaches, accommodating higher volatility while potentially fetching greater returns and lower overall transaction costs due to less frequent rebalancing.
Hence, you must closely monitor market behaviors and adjust your threshold widths accordingly to maximize gains while minimizing losses.
Constant proportion portfolio insurance (CPPI)
The CPPI strategy offers stability, ensuring a portion of your investment is safely tucked away in stablecoins. The CPPI strategy offers stability by allocating a portion of your investment to stablecoins, intending to shield it from excessive volatility.
This strategy is built on the premise of the linear relationship between wealth and risk. As your wealth grows, so does the associated risk. Allocating a portion of your portfolio to stablecoins serves as a potential buffer against market downturns.
Let’s consider a scenario where you aim to maintain a balanced stance by allocating $20,000 to cryptocurrencies and an equal amount to stablecoins in a 50/50 proportion.
Suppose the crypto sector experiences a bearish phase with a 50% decline. In that case, you will incur a loss amounting to about $10,000 on your portfolio. Conversely, if the entire investment amount of $40,000 had been channeled into cryptocurrencies, the potential loss would escalate to a staggering $20,000.
The incorporation of stablecoins in the portfolio could act as a safeguard, significantly mitigating potential losses and offering an opportune moment to reinvest in cryptocurrencies at lower prices during the rebalancing process, thus tactically navigating through market downturns. However, it’s essential to acknowledge that stablecoins are not without their own set of risks, including regulatory concerns and issuer risk.
Calendar (periodic) crypto rebalancing
The calendar rebalancing strategy takes a slightly different approach by focusing primarily on time rather than asset value or proportions. This means that rebalancing occurs at predetermined intervals, whether it be on an hourly, daily, weekly, or monthly basis.
The choice of rebalancing frequency depends heavily on several variables that influence threshold rebalancing, such as transaction costs and portfolio drift.
With this strategy, a shorter rebalancing period might lead to higher transaction costs. Still, it can effectively limit portfolio drift, ensuring the allocation stays within your desired setup.
On the other hand, adopting longer intervals for rebalancing proves to be cost-effective, albeit allowing a greater portfolio drift. This strategy calls for a personalized approach where you need to choose a rebalancing frequency that aligns with your risk tolerance and investment goals.
In conclusion, this strategy seeks to strike a delicate balance between maintaining portfolio integrity and mitigating costs associated with rebalancing.
Navigating the future
As you move forward, make smart choices when picking cryptocurrencies. Focus on quality and real value rather than getting caught up in the excitement. Successful investing requires vigilance; regularly review your portfolio and adjust as needed.
Above all, remember the golden rule: never invest more than you can afford to lose without causing financial hardship.
By following these principles, you’ll navigate the complex world of crypto investments wisely, ensuring both your financial security and peace of mind.