Portfolio rebalancing is a strategy that has been used by investors for decades. First, an investor must determine how much of their portfolio they want to allocate to each asset. In the case of cryptocurrencies, each asset would be a coin. These allocations are simply the percent of each coin that should be represented in the total value of the combined portfolio. When it is time to rebalance the portfolio, the coins are traded such that the value held in each asset is once again equal to the percentages that were originally specified.
Let’s look at an example. Say you have a portfolio where you have 4 different cryptocurrencies: BTC, ETH, LTC, and XMR. You have determined that you would like each of these four cryptocurrencies to have an equal 25% stake in your portfolio. This means, at the end of a rebalance, your portfolio would consist of 25% in each of these 4 assets. Since coins don’t generally cost the same per coin, the value should be calculated in fiat or a base currency, so the different coins won’t be equal in quantity, but in value. So, if you had $100 total between these four assets, you would have $25 in each after a rebalance took place.
This image shows a visual representation of what happens when a portfolio with equal weights is rebalanced.
Advantages of Rebalancing
With the trend of crypto investors “hodling” investments, rebalancing provides an opportunity to potentially boost these held earnings by taking advantage of rapid fluctuations in price. When a coin experiences strong gains, the rebalance will distribute those gains among the other assets. This means even if the value of the coin returns to the original price before the rise, rebalancing allows the portfolio to net a positive gain over this period.
In order to demonstrate the potential advantage over holding coins, we performed a detailed analysis with real market data over the last 1-year period. Based on our findings, rebalancing beats HODL by a median of 64%. After taxes, this represents 92% of all possible cryptocurrency portfolios.Without any work involved in managing the coins, performing trades, or changing allocations, rebalancing took holding to an entirely new level. You can see the rest of the analysis here:
You can see how well other portfolios would have performed over the last year by using our simple backtest tool.
Common Rebalancing Strategies
There are numerous rebalancing strategies, but we will only discuss two of the most common strategies.
Simple illustration depicting how periodic rebalancing takes place at specific times. After 24 hours, the allocations are not equal, so a rebalance will make them equal once again.
The simplest of these strategies is periodic rebalancing, which uses a fixed amount of time between each rebalance. This amount of time is usually shorter for cryptocurrencies than for other asset classes, due to rapid price fluctuations. For example, it would be reasonable to select a portfolio rebalance time of 1 day. This would mean that at the same time every day, your portfolio would be rebalanced.
This example demonstrates a 15% deviation threshold. We can see the green asset has reached the 15% deviation threshold because a current allocation of 23% means the green asset has deviated from its target allocations by 15%.
Rebalancing based on threshold deviations examines how far each individual asset has deviated from their target allocations. In the example illustrated above, we have selected to evenly distribute our allocations among 5 different assets. These 5 assets therefore each hold 20% of the entire value of the portfolio when we initially allocate the portfolio. Over time, we find the portfolio allocations for each asset deviate from their target allocation.
In order to prevent excessive deviation, we selected a max threshold of 15%. Once an asset diverges from their target allocation by more than 15%, a rebalance will be triggered. Trades will then be executed to once again reach the desired percent allocation for each asset.
Notice the threshold is a deviation from the desired allocation. It is not an absolute percent change. That means our assets don’t need to consume 15% more of the portfolio to become 35% of the total portfolio value. Each asset only needs to consume or lose 15% of their target allocation to trigger a rebalance.
The reason threshold rebalances are executed in this way is because diverse portfolios won’t be able to provide the necessary movement to trigger rebalances if the percentages were absolute. Imagine having a portfolio of 100 assets. If each of these assets holds 1% of the total portfolio value, it would be exceptionally rare to execute a rebalance even with a 1% absolute threshold.
Additionally, distributions of assets can be flexible. Not everyone is looking for even allocations. It’s possible to see a portfolio of 99% in a single asset. To provide consistency on when rebalances are executed, a relative percentage is used for threshold calculations.