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3 months ago

A Diversified Portfolio: The Basics of Portfolio Management


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This article describes the definition of portfolio management, how to build an investment portfolio, what it means to diversify it, and how all this works in crypto. More specifically, this article explains the necessary elements of an investment portfolio in general and in crypto in particular, the investment criteria that apply to different cryptocurrencies and coin types, and what a model portfolio might look like.


Contents

What is portfolio management?

Traders and investors usually avoid putting all their eggs in one basket: instead of focusing on just one investment or asset class, they build portfolios of different investments. Portfolio management is about selecting and overseeing a basket of different investments to achieve some long-term financial goal within an investor’s given risk profile.

There are two types of portfolio management ideologies: active and passive. In the former case, portfolio managers attempt to “beat the market,” while in the latter case they opt to invest alongside the market in an attempt to “match” it. The difference is that active portfolio managers will strategize and actively buy and sell financial assets to do better than the market, while passive ones will compose a diversified portfolio that mirrors one of the market indices in an attempt to match the market’s returns.

Efficient frontier for two stocks

Understanding portfolio management

Portfolio management today is based on Modern Portfolio Theory, invented by Harry Markowitz in the 1950s. It gives a mathematical form to the basic intuition behind diversification: namely, that it is safer to invest in a range of different assets or asset classes than in just one. It follows that one ought to assess an asset’s risk and return not in isolation, but in comparison to other assets in a portfolio. The same principles apply in the realm of crypto. The point then is to compose a portfolio of different assets in such a way that one’s returns will be maximized without increasing one’s level of risk.

In other words, one ought to move along the so-called efficient frontier, one of Markowitz’s key ideas, illustrated by the chart above. If the X-axis represents the risk, as the standard deviation of returns in %, and the Y-axis represents an asset’s returns, then a rational investor will make sure that his or her portfolio is always somewhere above the efficient frontier curve. Moving along the frontier involves taking different levels of risk, as illustrated on the chart. The line on the chart represents the efficient frontier, connecting dots that represent optimal relationships between risk and return for any given level of risk.

For example, a technology company like Google is inherently riskier than an established brand such as Coca Cola. Google is located in the top right part of the chart, indicating significant levels of both risk and return. Coca Cola is located in the bottom left of the chart, indicating low levels of both risk and return. Yet both dots are on the efficient frontier line—that is, in both cases the relationship between risk and return is optimal. That means, for Coca Cola, the return must be no less than about 2%, and for Google, no less than about 10%. Otherwise the relationship would not be optimal.

Portfolio composition involves choices and opportunity costs, for example, choosing between different asset classes, different temporal horizons, domestic or international markets, and the like. The goals can also be different: investing in “blue chips” that are stable and safe, or investing in “growth stocks” that are more volatile but potentially yield higher returns. Individuals can manage their portfolios on their own, or hire professional portfolio managers to do it on their behalf. There are also multiple organizational forms available for investors. For example, closed-end funds are typically actively managed, while exchange-traded funds (ETFs) replicate some market index.

A Sample Portfolio

Key elements of portfolio management

Portfolio management involves several distinct elements. First, assets must be allocated according to expected return targets and the risk profile. The idea here is that different assets diverge in their movement patterns, volatility, and returns. This diversity creates room for composing a portfolio rationally, making sure it accommodates one’s risk profile and return expectations.

Second, a portfolio must be diversified to ensure an adequate balance between risk and returns. Diversification allows spreading the risk across different categories: of assets (e.g. stocks or bonds), of geographical regions (e.g., Europe or Asia), and/or of industries (e.g., biotech or mining). If one fails, the others will not, because these categories tend to diverge.

Third, every once in a while a portfolio must be rebalanced in accordance with the goals and the risk profile. Asset prices and volatility levels change, so it is important to review one’s investment portfolio periodically so as to make sure it doesn’t evolve too far away from the initial goals.

The chart below demonstrates the benefits of diversification. Compiled by Ben Carlson, it shows the differences in year-to-day returns of a number of portfolios with different asset allocations. Each of the seven curves represents a portfolio with a specific ratio of different asset classes. The 100/0 is obviously the extreme case of no diversification at all (i.e. everything is invested in stocks), the 40/60 being the most diversified one. As can be seen, the most diversified portfolio suffers the least during a crash, while the most homogenous one incurs the largest losses.

Portfolio performance with different degrees of diversification

Portfolio management in crypto trading

The same principles apply to crypto trading. Cryptocurrencies are now a well-established asset class with a lot of internal diversity. Thus, it is possible to build portfolios of different coins with unique functions and value propositions and manage them, actively or passively, in a similar way to how it is done in the traditional stock market.

How many cryptocurrencies should be in your portfolio?

There is no consensus on how many cryptos one should have in one’s portfolio, but there is some evidence suggesting that about 20 different coins or other assets reap maximum returns.

What are the investment criteria for building a portfolio of crypto assets? Again, this is more a rule of thumb rather than a formal theory. Here are some useful tips on what to consider when choosing cryptocurrencies for a portfolio.

  • Value Proposition. What is the problem they are trying to solve? Ultimately, the value of a crypto depends on how well it solves a certain problem, be it the unreliability of fiat money (BTC), the necessity to rely on human trust in contracting (ETH), or the desire to enhance anonymity (ZEC).
  • Community. Cryptos are volatile assets and, unlike legal tender, are not as easily convertible and thus not as good at storing value. This makes the level of adoption a crucial consideration when choosing crypto assets for a portfolio. The greater the community of adopters, the better a crypto asset will fare—that is, the more they handle the money, the better for the investor.
  • Technology. If there is a solid value proposition and a sizable community, a crypto asset may have a bright future, which will be even brighter if it delivers on its value proposition in a novel way. Technology is a key component to the success of all cryptocurrencies, including the industry’s giants like Bitcoin and Ethereum, and thus is worth paying attention to. The next big thing in crypto will be technologically sophisticated, or it won’t be at all.
  • Governance. Like with other assets, it is important to ensure a good alignment of incentives among the different parties involved in mining or exchanging a cryptocurrency. Is there a way of beating the system by exploiting some unfair advantage? As cryptos become increasingly more complex governance-wise, it is important to factor this into one’s assessment.
  • Demand. The problem to be solved by a crypto must not be too exotic. The effective demand—the number of potential users and adopters—must be large enough, at least potentially. Otherwise, even if it’s utterly brilliant, the value proposition won’t attract enough money. In other words, there ought to be a market opportunity for an asset to be included in a portfolio.
  • Market Capitalization. Keeping an eye on this never hurts anybody, so don’t forget about this very important metric: it shows you how big an opportunity is out there.

Top five cryptocurrency portfolio trackers

Wait, but is it possible to monitor as many as 20 different coins in one’s portfolio, whether managed by an investor or by a fund manager on one’s behalf? In this case, portfolio management is an increasingly complex task, cognitively speaking. Fortunately, there is a solution.

Traders and investors usually rely on specialized software to manage crypto portfolios called portfolio trackers. That may sound complicated, but the idea is simple—they are software applications that implement the basic idea of portfolio management (asset allocation, diversification, rebalancing) within a graphic interface in a desktop or mobile app. They ought to be simple and intuitive, so that one can trade without bothering too much about the software itself. Here’s a brief summary of some of the best solutions currently available:

  1. Delta Investment Tracker supports as many as 3000+ coins and 300+ crypto exchanges, and allows you to create and manage up to 10 different portfolios. A good place to start.
  2. BlockFolio is a more advanced app with 8000+ coins and 300+ crypto exchanges. Features include real-time updates, portfolio categorization, notification alerts on price levels, automatic updates between your portfolio and exchanges, as well as a news feed. For those on the way to professionalization.
  3. Cointracking also offers real-time trade profitability and price alerts and supports 8 wallets. Its features are tailored more to sophisticated investors interested in 12 different methods of tax calculations and realized/unrealized gains breakdowns. Best for accounting purposes—and don’t forget to report your capital gains!
  4. Cryptocompare is a cloud-based platform that offers such features as risk analysis, IPO tracking and realized profit/loss calculations along with total revenue tracking. Such a repertoire of features puts it somewhere in between numbers 2 and 3—it’s more of a custom solution for investors with specific demands. It also supports 5000 coins!
  5. KriptoGraphe is the fifth in the top-five ranking with its features of portfolio comparison, FIFO-based accounting, and a list of the top coins by market capitalization, as well as news. It has all the necessary features of a portfolio tracker, even though the exact profile is unclear.

A more detailed comparison of portfolio trackers is available from 3Commas Academy. Choose the one that suits you best, and start trading.

Key takeaways

Portfolio management is the activity of building and overseeing a portfolio of different assets to meet one’s financial goals within a given level of risk exposure. Portfolios can be actively managed, where investors or their fiduciaries actively buy and sell stocks to “beat the market” and achieve higher returns. Passive management refers to building a portfolio that “mirrors” the market by replicating one of the representative indices.

Portfolios are constructed through asset allocation, which takes into account different features of different asset classes and their contribution to the portfolio’s overall risk, diversification helps spread the risk across different assets, and rebalancing is needed periodically to ensure tight coupling with the initial financial goals.

In crypto, the same principles apply. A typical crypto portfolio will include about 20 different coins. To monitor them, it is useful to rely on one of the available crypto portfolio tracking apps.

FAQ

What is portfolio management?

Portfolio management is the activity of selecting and overseeing a basket of different investments to achieve some long-term financial goal within an investor’s given risk profile. It can be active and involve continuous buying and selling of financial assets to do better than the market, or passive, whereby an investor composes a portfolio that “mirrors” the market and does not intervene.

What are the key elements of portfolio management?

The portfolio management process proceeds in three stages: 

  1. Asset allocation, i.e. determining the asset classes to compose a portfolio from; 
  2. Diversification, i.e. spreading the asset-specific risks by investing in a range of different asset classes, industries, or regions; 
  3. Rebalancing, i.e. periodic assessment of the portfolio’s performance and alignment with the initial financial goals.

What does this have to do with cryptos?

There are many cryptocurrencies with different characteristics available out there, so a range of portfolios can be built purely in crypto. The same principles of portfolio management that work for more conventional financial assets also apply here. As a rule of thumb, 20 different cryptos are considered a good fit for most investing purposes.

How do I manage a crypto portfolio?

There is a range of software solutions available for different purposes and budgets. You can compose, track, and manage crypto portfolios using specialized apps developed to do just that, plus help you navigate the complexity of the crypto market.