Easy and safe investing through diversification?

We have shown you two methods of risk management:

1. Volatility targeting

2. Investing in rising markets only(Yes, as that avoids a big chunk of downside volatility, its actually a risk management tool!)

We have mainly considered investments in one coin (Bitcoin) only because this makes it easy to explain the concept and logic of our strategies. Other coins have, obviously, differing returns, MDDs, winning ratios and profit-loss ratios. However, just have in mind that the conclusions are about the same.

And as you know, there are thousands of cryptocurrencies. Diversifying in other coins is a very sound investment strategy – you might have heard the saying “Don’t put all your eggs in one basket.”

However, to give you the conclusion first, you can reduce risk by diversifying in various coins, but its far less effective than volatility targeting we have introduced above.

Why? Financial assets have a less strong correlation in bull markets. That’s why only some stocks move up during bull markets while lots of stocks just fail to move.

However, in bear markets, the correlations generally increase, causing all coins to fall simultaneously.

Therefore, it is pretty foolish to say: “I am invested in 20 coins. Even if Bitcoin moves down 80%, I will be safe through diversification!” If Bitcoin falls that much, other coins will certainly fall. There are tons of different coins, but they all act like a family if a heavy bear market arrives. Some coins will fall more and some will fall less, but they will all fall.

However, there is even a man who was awarded the Nobel Prize in Economic sciences for his contributions to portfolio diversification. So let’s have a look at it.

Harry Markowitz got his Ph.D. by formulating “invest in asset with low or negative correlation”, and as the world found out how great his advice was, he was awarded the Nobel Prize for Economic Studies in 1990.

What exactly is correlation? People with mathematical background will already know, but it shows how closely two assets move together. Correlation ranges are between -1 and 1. If two assets have a correlation of -1, the returns of two assets perfectly move in the opposite direction.
If the S&P moves up 0.4% and Bitcoin falls by 0.4%, and this relationship repeats every day, S&P 500 and Bitcoin would have a correlation of -1. On the other hand, if Bitcoin moves up 0.4% while the S&P moves up 0.4%, both assets have a correlation of 1.
Obviously, in the real world, there are no two assets with correlations of exactly -1 or +1. You might interpret correlations in the following way.

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▲ The meaning of correlation

For diversification purposes, low or negative correlation is good. The higher the correlation, the worse it becomes. If you have two assets, A and B, and if they fall together, what is the use of diversifying into two assets? On the other hand, if the correlation is strongly negative, you have some real benefits. For example, the Korean stock index and US-dollar denominated US government bonds have a correlation of around -0.4. So, if Korean stocks fall, US government bonds tends to rise, which gives you excellent diversification benefits.

What about the correlation of cryptocurrencies? Sifrdata (www.sifrdata.com) continuously updates the correlation between cryptocurrencies.

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▲ Correlation among major cryptocurrencies (March 13, 2017, 90 days correlation)

If you look at the chart, you find out that the correlations between cryptocurrencies are pretty high. So a ‘diversification’ of Bitcoin through Ethereum does not really fulfill its purpose.

But still, if you buy one cryptocurrency only, you can imagine that your risk is pretty high. The coin might suddenly go out of business! How many currencies should we buy, then? There are actually people who have written academic papers to this subject. But note that you cannot diversify your assets away by just buying hundreds of different cryptocurrencies into your portfolio. I already told you that all cryptocurrencies will fall together if a bear market arrives! But if you buy multiple coins, you can diversify away some coin-specific risk. What if you had invested in “Bum-Coin”, and this coin suddenly disappears from the face of the earth? But if you had invested in 5 or 10 different coins, the probability of all coins disappearing at the same time is pretty low.

Many investment books claim that buying 20-30 coins is the best way to maximize diversification benefits. However, there are not that many liquid coins to diversify into. Kangcfa, for example, deals with the 5 currencies offered by the Korbit exchange – Bitcoin, Ethereum, Ripple, Bitcoin Cash, and Ethereum Classic.