How To Diversify Away Risk In A Crypto Portfolio: Correlation And Variance

Although there are public companies whose stock movements have strong correlations due to those doing similar work in the same industry - oil companies, for example - investors are still capable of diversifying away risk in an equally weighted portfolio by adding stocks with negative correlations to the portfolio.

If crypto-assets fall victim to high correlation coefficients, would it be possible to diversify away risk in an equally weighted cryptocurrency portfolio by adding more crypto-assets? To answer this question we will analyse the expected returns and standard deviations from a series of portfolios constructed from Bitcoin, Ether, Litecoin, and Ripple.

In a two asset portfolio the expected returns will increase in respect to every single-asset portfolio except when comparing the Litecoin-only portfolio to the LTC-XRP portfolio, the Bitcoin-only portfolio to the BTC-LTC and BTC-XRP pairs, and the Ethereum-only portfolio to the ETH-LTC, ETH-XRP, and ETH-BTC pair.

In the BTC-ETH portfolio, Ethereum's average return is higher than Bitcoin's average return; so when the portfolio's expected return is averaged, the expected return for the two-asset portfolio is higher than the expected return for the BTC-only portfolio - for example 2 >1, 1+2 =3, 3/2 =1.5, 1.5>1.The standard deviation associated with a portfolio consisting of two assets is lower than the SD of every single asset portfolio.

The standard deviation associated with holding a three-asset crypto portfolio will increase in comparison to every two-asset portfolio except those with LTC-XRP, BTC-XRP, and BTC-LTC, their SD will decrease when you add a third crypto-asset to the portfolio.

So how to diversify away risk in crypto portfolios?

Although digital assets are highly correlated, it is possible to diversify away risk in a crypto-only portfolio by adding more crypto assets to the portfolio.

It is possible to diminish standard deviation when you move from a single-asset portfolio to a two-asset portfolio in 3 out of the 6 possible two-asset portfolios; from a two-asset portfolio to a three-asset portfolio - in respect to 3 out of 6 two-asset portfolios, and in a four-asset portfolio - in respect to 1 of the 4 three-asset portfolios.

The reason you are able to diversify away risk in a crypto-only portfolio even though the crypto-assets are highly correlated could be because there are different types of risk, as Sumanov said to Cointelegraph.

The analysis shows that spreading wealth over a number of assets, instead of putting all into one, could diversify away the idiosyncratic risk that is unique to a particular digital asset, and the more risk one is able to diversify away, the better situated he could be to protect himself against losses in the cryptocurrency portfolio.