New research has suggested some key ideas for making the most from your crypto. And it’s not just about HODLing, nor is it just about Bitcoin…
Cryptocurrencies are high risk-high reward assets to invest in and managing those risks comes with significant difficulties.
But a new joint research paper from two UK universities claims to have found the best model to return higher yields on cryptocurrency investments at substantially lower risk.
Researchers Emmanouil Platanakis at the University of Bath and Andrew Urqhart from Henley Business School at the University of Reading released this paper on the SSRN research network.
“The interest in cryptocurrencies is growing especially as an investment,” says the paper, with “the diversification benefits of Bitcoin to other financial assets [clear].”
Collecting weekly data on Bitcoin (BTC), Litecoin (LTC), Ripple (XRP) and DASH over the course of four years from February 2014 to May 2018, the research team focuses on these four as the most liquid cryptocurrencies, that is, those with the most buyers available when sellers come to the market.
Even given cryptocurrencies’ 80% price drop from their all time high around December 2017-January 2018, there is strong evangelical sentiment among investors that if they hold on, there will be brighter times on the other side.
However, there are ways of managing your investments beyond the naivety of simply HODLing.
For those who are interested, there is a piece of research here which looks at how much investors would have gained or lost had they bought the top 10 cryptocurrencies in December 2017 and enacted no trades at all, instead just holding on to all their initial investments.
Recent research finds “substantial benefits from including Bitcoin in traditional portfolios”, say the pair.
However, “cryptocurrencies have been found to be highly volatile and therefore have higher potential estimation errors in their parameters”.
Estimation errors are a measurement of how accurate a prediction is. Controlling risk in the face of such wild volatility is extremely challenging, even for experienced portfolio managers.
The received wisdom of investing is to spread your stock or cryptocurrency buys across a wide variety of sectors and providers, in order to minimise risk in the long term.
The methods by which you choose these buy-ins is a source of robust debate among portfolio managers.
The critical questions for any investor are: ‘Where should I allocate assets for the strongest long-term portfolio? Which assets should I buy to provide the best chance of a reasonable return, at the lowest possible risk?’
Investors who are experienced in the stock market will usually hold a basket of different cryptocurrencies, knowing as they do the diversification model.
Platanakis and Urqhart write: “We observe that the Black-Litterman approach…outperforms both the 1/N and Markowitz benchmarks indicating that the advanced portfolio optimisation model offers higher risk-adjusted returns for a cryptocurrency portfolio, inclusive of transaction costs.”
What is Black-Litterman?
Black-Litterman is a mathematical model for predicting the best portfolio allocation; in essence, where investors should put their money. The model was developed by Fischer Black and Robert Litterman at Goldman Sachs in the early 1990s.
Investment analysis research firm MorningStar gives a step-by-step guide to the methodology here.
The other benchmarks noted are 1/N, also known as naive diversification, and Markowitz, a popular method of portfolio management dating back to 1952.
The Black-Litterman model essentially shuns portfolios which are highly concentrated in any particular area.
Platanakis and Urqhart find that the 1/N and Markowitz methods of diversifying a portfolio do not stack up when placed in opposition to Black-Litterman.
Research by The Bank of England came to a similar conclusion, albeit testing on traditional and non-cryptocurrency markets.
Why is this important?
Investors starting to build a portfolio will normally rely on historical analysis, as well as fundamental analysis, to inform which stocks, treasuries or other commodities they might buy into. For traditional, non-cryptocurrency assets, those historical analyses can be developed over the course of decades. Cryptocurrencies are much newer, and don’t have this weight of history behind them.
Transaction costs on trades are often high and can make a significant impact on profits if one trades too frequently. Anyone who has bought cryptocurrencies using Coinbase will know this, at £2.99 per trade, and this is replicated in the traditional market. For the largest retail-focused stock investment platforms like Hargreaves Lansdown, Vanguard or AJ Bell, the cost can be upwards of £7 every time you buy a stock. It makes a reasonable amount of sense to make fewer buys throughout the year.
Platanakis and Urqhart say their research is “robust to the inclusion of transaction costs and short-selling”, which suggests that sophisticated portfolio techniques that control for estimation errors are preferred when managing cryptocurrency portfolios.
Historical returns, for example the amount of dividends a fund has paid out to shareholders in the past, are a reasonable way to broadly estimate future possible returns. The possibility of error is large though.
Blockchain is not going away. Its use cases across digital ID verification, supply chain management or interbank payments are in their very early stages, and yet there is much to cheer.
While these diversification models may seem esoteric, it’s important to investors to be able to make returns on their investments.
The Sharpe ratio, developed in 1966 by economist William Sharpe, is one of the more important tools to rank the performance of a portfolio.
Essentially, it measures the risk-adjusted returns of any investor’s portfolio: one with a higher Sharpe ratio is considered superior to its immediate peers.
Plantanakis and Urqhart’s measurements of Bitcoin, Litecoin, Ripple, and DASH from 2014-2018, even allowing for short-selling, show that Black-Litterman model produces the best Sharpe ratio for investors.
When trying to decide where to put their money for the best returns, investors are effectively trying to predict the future.
This, in its most naked form, is practically impossible. We can make educated guesses based on which companies have good management teams, strong cashflow, low levels of debt and a large market for their products. But to suggest that anything is ever certain is just foolish.
But the lessons we can learn from traditional investing are clear. In the case of this paper, following a Black-Litterman model seems to yield the best results. That means diversifying your investments across sectors, from cryptocurrencies that are intended to take on payments industries, those dealing with supply chain management, to decentralised cloud computing.
Investing only in Bitcoin is a sure-fire way to lose every advantage you had.