Sharp Decline (Flash Crash)
A sharp decline is the case where the value of an asset in your portfolio drops quickly and then stabilizes to a new baseline value.
This graph illustrates a sharp decline and then stabalization. The white line is the price of a single asset in a portfolio. The orange line is the value of the portfolio if the HODL strategy is used from beginning the end. The blue line is the value of the portfolio if a rebalance was performed at the white dot. Result: rebalancing and HODL produce similar results for this type of sharp decline.
HODL of an asset which has a sharp decline simply results in the reduction of portfolio value directly proportional to its own value decrease over time.
The results for this situation are the same as those of HODL. While the single asset crash resulted in a net decrease for the portfolio, a rebalance at the dot does not introduce any additional loss in funds. Rebalancing anywhere along the decreasing line before the dot would result in additional loss (See “Slow Death”).
Both rebalancing and HODL perform the same in this instance when looking at the complete portfolio value. Rebalancing at the dot will accumulate more of the asset which had a sharp decline, however, the stabilizing price afterwards means no additional loss in portfolio value is observed.
The slow death is when a single asset continues to decline in value. Week over week, it slowly continues to decrease in value.
This graph illustrates a slow death. The white line is the price of a single asset in a portfolio. The orange line is the value of the portfolio if the HODL strategy is used from beginning the end. The blue line is the value of the portfolio if a rebalance was performed at the white dot. Result: HODL beats rebalancing. The innovative investor should watch their portfolio to detect this type of slow decline.
HODLing an asset which is having a slow death results in a net decrease in total portfolio value. However, this slow death does not affect the value of any other holding. So while the total value of the portfolio is decreasing, the subset of the portfolio which excludes the asset which is having a slow death, does not have any decrease in value.
Rebalancing into an asset which is having a slow death decreases portfolio value. In addition to the value of the individual asset declining, it is actually also declining the value of the rest of the assets in the portfolio as well. So, this means that both this individual asset as well as the rest of the portfolio is bleeding.
This is a undesirable situation to be in when rebalancing. Continually rebalancing into a dying asset will drag the entire portfolio down with it. If you are using a periodic rebalancing strategy, it is important to monitor your assets to ensure this is not the case for your portfolio. Having a diverse portfolio will also mitigate these risks since a smaller percentage of the total portfolio value will be held by the single asset.
Flash Crash and Recovery
There have been several famous flash crashes which were followed by quick recoveries in crypto. The one discussed at the start of this article was when ETH flash crashed to 10 cents. This may not be a weekly event, but we can examine how rebalancing would have affected your performance during this flash crash and recovery.
This graph illustrates a flash crash and recovery. The white line is the price of a single asset in a portfolio. The orange line is the value of the portfolio if the HODL strategy is used from beginning the end. The blue line is the value of the portfolio if a rebalance was performed at the white dot. Result: rebalancing results in greater returns than HODL for this type of flash crash and recovery.
The results of HODL for this situation are the same as the pump and dump scenario. Since the beginning and ending price are both the same value, HODL will result in no change of value for the portfolio.
Rebalancing can capitalize on these flash crashes to result in a net positive increase in portfolio value. When rebalancing, we buy more of the volatile asset while it’s cheap. Since the price of the asset returns to the original value, the net result of a rebalance anywhere along the pump or dump curve is a positive return for the portfolio.
Catching flash crashes with rebalancing can increase the value of a portfolio. In order to highlight how significant this would have been in the case of the ETH flash crash, catching this flash crash would have resulted in up to a 1595x return for your portfolio. While this will likely never happen again, it’s not unlikely that smaller flash crashes with recoveries will take place which rebalancing can capitalize on. This illustrates how predicting the future isn’t possible in the crypto space. Creating a stop loss and selling ETH as described at the start of this article would have resulted in large losses. However, continuing to rebalance through the crash would have presented potential for incredible gains.
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