Crypto Volatility, and Why Rebalancing Your Portfolio Is Key

This article was written by CoinShares in collaboration with Peaks.

Asset allocation is a crucial strategy for managing risk when constructing a portfolio, especially in volatile markets like cryptocurrency. It involves deciding how to distribute your investments among different asset classes, like stocks, bonds, and cryptocurrencies. Properly defining this allocation is crucial as it establishes the portfolio's long-term return and risk potential, influencing its performance. But sometimes along the way, a certain holding might outperform, skewing the portfolio’s weightings and shifting its risk profile. To counteract this effect, you need to revert to the original allocation, a strategy known as rebalancing. Read on to learn how.

Why Is Crypto So Volatile?  

As you can see in the chart below, crypto is one of the most volatile asset classes. 

• Crypto is subject to investors allowing their emotions, such as greed or fear, to inform their decisions. The market is particularly sensitive to media hype and social media noise,.
• The regulations governing crypto trading vary from country to country (or region), and they constantly evolve as crypto is a relatively immature asset class. While greater clarity may encourage some investors, it can put off others (as we explain below). 
• Unlike traditional asset classes, the technology underpinning a digital currency- a shared ledger called a blockchain- influences its value. Tech advances can support prices, while threats have the opposite effect. 
• Bitcoin shares many characteristics with gold, which traditionally serves as a ‘store of value’ during phases of economic or political instability.
• As BTC/ USD is the most common trading pair, bitcoin strengthens when the US dollar weakens and vice versa.  

Here are a couple of examples to show how these forces affect the price of bitcoin. 

To understand how bitcoin’s tech acts as a catalyst, you need to know how transactions are processed. Miners use sophisticated hardware to complete complex mathematical problems, and the first to come up with a solution wins the right to process the latest batch of transactions and earn a reward paid in bitcoin. Every four years the reward halves - it currently stands at 6.25 bitcoin. When the last ‘halving’ took place in May 2020, it had the potential to be 'priced in' during the previous three months, as bitcoin climbed from just over $5,000 to more than $9,500. This means that people might have been expecting the halving to happen, and this expectation could have influenced the price of bitcoin.

Next, let’s return to how regulatory clarity can discourage investors. When Chinese authorities prohibited financial institutions and payment providers from processing bitcoin payments in 2021, the price plunged 30% within 24 hours. Four months later, China banned crypto trading and mining. This was a significant development for the crypto industry as China hosted 70% of the world’s mining activities at the time. Bitcoin responded by falling more than 9%. 

How Asset Allocation Works

Asset allocation is an investment strategy that involves splitting your capital between different asset classes, typically shares, bonds and cash but also alternatives such as crypto. The main benefit of asset allocation is it helps you to build a diversified portfolio consisting of investments that respond differently to market conditions, so outperformance by one makes up for underperformance by another. This reduces risk. 

When deciding on the right asset allocation for your portfolio, you should ask yourself three questions:

• What are your goals? What do you want to achieve with your investment? 
• What is your time horizon? How long are you prepared to hold your investment? 
• What is your risk appetite? How much risk do you feel comfortable taking?  

Another benefit of asset allocation is that it encourages discipline. Avoiding hasty decisions is important when investing in an asset as volatile as crypto. 

From time to time, one investment outperforms the others. This effect skews the weightings of your asset allocation and impacts the risk profile of your portfolio. For example, a standard allocation is 60% shares and 40% bonds. If shares outperform, the weighting could switch to 70% shares and 30% bonds. Shares are more volatile than bonds, so the portfolio’s risk exposure increases.

How to revert to the original allocation 

A strategy called rebalancing restores the original asset allocation. There are the two main approaches:

• At a certain frequency, such as annually, quarterly or monthly. 
• When a portfolio deviates from the original allocation by a certain percent. 

Remember that the more often you rebalance, the more time you spend monitoring your portfolio. And some investment platforms require you to pay transaction fees for each rebalancing (at Peaks, rebalancing costs you nothing extra). Rebalancing if your portfolio deviates by more than 5 percentage points is considered standard practice. 

Crypto rebalancing 

Rebalancing a crypto holding – not to mention investing in the first place – is complex due to the relative inaccessibility of the market compared to traditional asset classes. You usually have to buy directly on a crypto exchange, which may be unregulated or underregulated. You also need to figure out how to securely store your assets, either on the exchange or in your own hot (online) or cold (offline) wallet. However, there's an alternative. You can gain exposure to crypto by investing in exchange-traded products (ETPs) that trade on mainstream exchanges and can be held in your portfolio along with traditional asset classes.

Including crypto in your portfolio makes rebalancing even more important, particularly given the high volatility of crypto. Consistent rebalancing can provide valuable benefits by harnessing the power of the rebalancing effect. When crypto prices experience significant increases, leading to a higher portfolio weight, rebalancing allows you to sell some crypto assets, effectively 'selling high.' Conversely, when crypto prices drop substantially, causing their portfolio weight to decrease, rebalancing enables you to purchase more crypto, essentially 'buying low.' This process helps maintain portfolio stability while capitalizing on market fluctuations.

What rebalancing can do in a diversified portfolio with crypto

To measure how bitcoin affects the returns of a diversified portfolio, we can compare three example portfolios: 

• An allocation of 60% equities and 40% bonds
• A standard allocation with 4% bitcoin
• A standard allocation with 4% bitcoin that isn’t rebalanced

Each of the portfolios is balanced quarterly, apart from the last one. 

Various asset classes performance in a balanced portfolio (since Oct 2015)

	60%/40% benchmark (aandelen/obligaties)	4% Bitcoin	4% Bitcoin zonder herbalanceren
Annualised returns	6,.%	13.3%	40.1%
Maximum loss	21.4%	22.9%	67.2%
Volatility	9.3%	10.3%	42.2%

Source: Bloomberg, CoinShares, data available as of close to 30 October 2024

• Data derived from a balanced 60/40 equity/bond portfolio, with an equal weight detraction to allocate to Bitcoin, goud, HFRX Global, CRB, REITs Top 5 Crypto

• MSCI World total return, Bloomberg Total Return 7-10 year bond, XBTUSD, goud, HFRXGL Index, CRB & REIT indices are used

• Rebalanced per calendar quarter

When assessing the return-risk trade-off between the unrebalanced portfolio and the 4% Bitcoin quarterly-rebalanced one, it becomes evident that the latter offers a superior outcome. While the unrebalanced portfolio might generate the highest returns on the surface, it does so at a substantial cost in terms of risk. The pronounced drawdown and heightened volatility experienced by the unrebalanced portfolio expose investors to a substantial level of uncertainty and potential losses.

Conversely, the 4% Bitcoin-rebalanced portfolio strikes a harmonious balance between returns and risk. By periodically reallocating to maintain the 4% Bitcoin allocation, this strategy mitigates the risk associated with an unchecked Bitcoin allocation's growth over time. As shown in the table, Bitcoin's remarkable surge since 2015 could lead to an unbalanced and disproportionately large share of the portfolio without rebalancing, which, in turn, significantly amplifies the risk. The rebalanced approach, on the other hand, capitalises on Bitcoin's growth while ensuring a prudent risk-management strategy, resulting in strong returns with reduced volatility and a smaller drawdown.

Please note: This article is not intended as investment advice but provides additional information about investing in crypto and crypto ETPs. Investing in crypto ETPs can be considered 'complex' and involves financial risks such as high volatility and significant drawdowns in value. It's always important to carefully consider the financial risks by reading the essential information document and prospectus and to have a well-diversified portfolio for long-term investing before investing in crypto ETPs.

Investing always involves risks. Know that you could lose (a part of) your invested money.