Analysis: How Monero can reduce risk in cryptocurrency portfolios
A new research paper suggests that cryptocurrency investors could use Monero to construct a more efficient portfolio, hedging against the wild volatility that has become the byword for digital asset investing by looking at correlation.
The paper, titled An Analysis of Cryptocurrencies Conditional Cross Correlations, was produced in November 2018 by three researchers at Universitat Rovira i Virgili in Reus, north-west Spain.
Nektarios Aslanidis, Aurelio F. Bariviera and Oscar Martínez-Ibañez carried out price analysis on Bitcoin, XRP, Dash and Monero between 2014 and 2018.
Their results reveal that Monero has the lowest correlation of any of the four cryptocurrencies.
Why Is This Important?
Well, as the paper states: “One key aspect in portfolio theory…is the correct assessment of correlation returns among different assets. Such metric has important implications regarding portfolio construction, risk analysis and hedging.”
Traditional investors will limit risk with asset diversification: spreading their investments between real estate, stocks, bonds or commodities to guard against losses in any one sector.
In its simplest terms this is the same advice as the 17th century proverb: don’t put all your eggs in one basket.
Cryptocurrency investors should also diversify their investments in the same way, according to the latest academic research. Investing only in Bitcoin is a surefire way to up your risk, and traders can hedge against volatility by spreading their buys out to Ethereum, TRON, VeChain or any other well-performing coin.
Another way to limit risk in your portfolio is to search for assets (stock, bonds, cryptocurrencies, gold etc) with low correlations. That is, assets whose price spikes and falls are not closely related.
If you do choose to buy and hold assets that are highly correlated – so when the price of one goes up or down, it’s more likely that the price of the others will too – then there is a risk that a market crash in one sector could wipe you out.
In other words: when the king falls, so do his armies.
While September to early November 2018 saw generally low volatility in the cryptocurrency trading markets, the Bitcoin Cash hard fork on November 15 sparked a major sell-off, plunging the price of Bitcoin down to the low $3000-mark.
Because so many altcoins are so closely linked to the price of Bitcoin, they tend to drop in price when Bitcoin does.
The researchers looked at data from 21 May 2014 to 27 September 2018 using daily price data from CoinMarketCap. They write: “Our study detects several interesting features in the cryptocurrency ecosystem.
“On average, correlation between cryptocurrencies is positive. Note there is low variablility in all correlation pairs with Monero.”
Correlation is scored on a range between +1 and -1. More positive numbers reflect prices that are closely linked while negative numbers indicate that prices tend to move in opposite directions.
Aslanidis, Bariviera and Martínez-Ibañez found that while “cryptocurrency volatility raises doubt about their suitability as a store of value,” the numbers show that “correlations including Monero [are] more stable in time than other correlation pairs.”
In other words, when you compare the amount that a cryptocurrency price swings over time, the lowest correlations are found between Bitcoin-Monero: 0.031, XRP-Monero: 0.032, and Dash-Monero: 0.038.
￼￼￼￼The largest variance was found between XRP and Dash. Correlation ranged from +0.71 to -0.51.
The research team conclude: “Our results have important implications for portfolio analysis. An investor, who constructs a dynamic hedge portfolio of cryptocurrencies could take into account the stable correlations involving Monero.
How Amateur Investors Turn Pro
Fund managers don’t pick what to invest in based on hunches, or educated guesses. Often they will use tools to find these ‘uncorrelated assets’ to diversify which assets they hold on to, which they sell, and which they buy.
So while this level of statistical analysis may be the purview of professional money managers, there is no reason why individual retail investors cannot take advantage of the economic literature.
The point of picking assets with lower degrees of correlation is to diversify your cryptocurrency portfolio and to make sure a Bitcoin price plunge doesn’t put you in serious trouble.
Essentially, those coins or tokens that don’t drop off a cliff when Bitcoin has a bad day: these are the ones you should focus on picking up in order to diversify your portfolio and guard against market drops.
And when it comes to hedging against volatility, this research appears to prove that Monero is one of the safer bets.