Does rebalancing an allocation of cryptocurrencies make sense?

One of the features offered by the Prism exchange is the ability to “rebalance” your basket of currencies back to its original allocation. Given an investment vehicle in which you create an allocation, it might seem natural to offer a rebalance feature. But does this make sense?

In Markowitz Portfolio Theory, a portfolio is constructed of multiple, uncorrelated asset classes (in the real world, that means stocks, bonds, precious metals, etc. which, as we know, are not perfectly uncorrelated.) The allocation of the asset classes determines the risk level of the portfolio. For example, 90% stocks and 10% bonds is much riskier than 10% stocks and 90% bonds. It’s assumed that one investor will have different appetite, need and capacity for risk than another, such that there’s no one-size-fits-all allocation.

Over time, as a portfolio deviates from its original allocation, it implicitly deviates from its risk profile. To return it to its risk profile (assuming the characteristics of the asset classes haven’t changed), we can rebalance it. And doing this systematically over time has been shown to also add value, since we’re systematically selling asset classes when they are high, to buy those which have dropped. Many call this the only free lunch in investing.

The extent to which rebalancing makes sense and works, however, is a function of the extent to which the underlying asset classes are uncorrelated, and have a tendency to revert to the mean. So it’s critically important that when one zigs, the other zags. (Interestingly, the accessibility of the modern Exchange Traded Fund (ETF) has increased correlation of a number of asset classes like commodities, with equities and bonds, such that many experts wonder how long rebalancing will continue to be a free lunch.)

And this is why rebalancing doesn’t really make sense in the context of a basket of cryptocurrencies. Although it’s still early, and things can change, currently, as anyone who watches CoinMarketCap will attest, cryptocurrencies appear to be almost perfectly correlated! When you’re selling Bitcoin low, you’re likely going to be buying Ethereum low as well.

So be careful out there—we have to be very careful when blindly applying traditional investing concepts to emerging spaces like crypto. (In that regard, next on my radar is thinking about whether it makes sense to track a marketcap-weighted index of crypto.)

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