Beyond BTC/ETH: The Benefits of Diversifying your Crypto Portfolio

When it comes to investing in cryptocurrencies, the long term stable choice has always been Bitcoin, with Ethereum coming a close second.? Given the current bear market, many crypto investors have become significantly more conservative with their holdings.? I believe that this bear market is only temporary – that the fundamental technology behind blockchain is the future of finance, and that the current temporary market is a good time to accumulate.??

With this thought in mind, I, like many others in the market, withdrew to just Bitcoin and Ethereum in May.? But was this the right decision?

This, on the surface, seems wise – after all, Bitcoin is the least risky cryptocurrency in terms of variance – It is undoubtedly true that Bitcoin is the single safest crypto investment compared to all others.? So how is it possible that a diversified portfolio beats Bitcoin???

Risk works in a very different way to how you might expect – risk is non-linear, and not additive.? Return, by contrast, acts exactly the way you would expect it to – when you combine a low return asset with a high return asset, you end up with a portfolio with middling returns.

Risk, on the other hand, works differently.? It is quite possible to take several highly risky assets and combine them in such as way that they have a lower risk than even the least risky of them.? The reason why this is possible is because there are two contributors to the overall risk of a portfolio: 1. The risk (variance) of the assets making up the portfolio, and 2. How correlated the assets are to each other.

Assuming that assets aren’t perfectly correlated to each other (and assets that aren’t direct derivatives of another usually are not perfectly correlated), 2. allows you to build an overall portfolio with lower risk than any of the constituent assets.

This is key to how diversification can help a purely Bitcoin portfolio – what this means is that it’s possible to reduce Bitcoin’s risk by combining it with other coins that are, individually, more risky than it.

OK, so we understand that in theory we can beat Bitcoin through a diversified portfolio, how does it look in practice?? We can use the Safeforge portfolio constructor (refresh if it doesn’t work the first time) to see how different diversified portfolios perform compared to BTC.

If we start with a portfolio that is weighted 100% by market cap (which is the traditional method of weighting indices), we end up with a portfolio that is majority Bitcoin.? So it’s not a huge surprise when we see that this portfolio mostly follows Bitcoin.? What we can see from the chart below is that the diversified portfolio beats Bitcoin quite comfortably over the past 18 months, while it significantly underperforms Ethereum.

We can weight with different factors as well.? One of my favourite factors is velocity – essentially, a measure of how much of the supply of a coin/token is circulating over a given time.? Since many of these coins either are designed as a substitute for money or with some specific utility in mind, the velocity is a good measure of how well the coin is doing it’s job.??

If we built a portfolio weighted 60% towards Velocity and 40% towards Market Cap, we would get the following:

Pretty good, right?? We have a portfolio that is highly correlated with Ethereum, but beats Ethereum over the 18 month period.? What we also see is that this portfolio is far more risky that Bitcoin (or the pure market cap portfolio shown above).? A good metric for comparing this portfolio with Bitcoin is the Sharpe Ratio – essentially the Return divided by the Risk, or in other words, the risk adjusted return.??

Another factor that’s very popular among people is momentum – weighting coins by how much they’ve risen over a previous period.? What you can see with our portfolio creator is when we weight by 180 day momentum (in other words, giving high emphasis to coins that performed better over the previous 6 month period), we end up with a portfolio with an even higher sharpe ratio – encompassing many different coins.

What we’ve seen here is a fairly constant trend – diversified portfolios seem to perform better than an undiversified asset over a long run period.? Whether they’re lower risk diversified portfolio (like the market cap one outperforming BTC), or a higher risk one (like the momentum portfolio outperforming ETH), building a strongly diversified portfolio can significantly improve the performance of your crypto portfolio.

If you would like to build your own portfolio with factors, check out Safeforge’s portfolio builder: https://safeforge-portfolio-builder.vercel.app/. (You might need to refresh if the builder doesn’t work immediately)? We’re running a competition with a $300 first prize for the best performing portfolio.

We’ll then combine these tokens into a single, optimised, index token.? Check here: https://www.safeforge.finance/ for the Whitepaper and more information.