This has been something I have been meaning to get around to for a while now, which is trying to explain the inner working of the crypto market. I’m going to be writing this in a 3-part series as its important to understand 3 key theories in a simple way that hopefully even beginners can understand.
1. Correlation Diversification
2. Arbitrage triangles
3. Sats vs dollars
So in the first part of this article I’m going to explain Correlation Diversification, and I find its best to use a lot of analogies that people can relate to and then convert it into the workings of their market to bring it all together, so let us begin. What is Correlation Diversification, by Denomics
Diversification is something we as investors and traders use to minimize risk by not putting all our eggs in one basket, it seems simple enough and most people have the basics down. But some people never bother to educate themselves or take the time to understand Correlation Diversification, which is a theory or practice that involves diversifying across uncorrelated assets and why sometimes your diversified portfolio may not actually be doing the job you are wanting it to. Remember the whole point of diversifying is to not put all your eggs in one basket.
So, what does this mean?
well you see believe it or not, some assets prices move together, this is called Asset Correlation and I will give you some examples of correlated and uncorrelated below.
Let us say a barrel of oil soars up 10% overnight, you would expect to see the price of petrol at the pump rise the following day……. this is an example of a correlated asset class. Now let us say the price of a Big Mac goes up 10%, do you think a price of a bottle of water at the supermarket changes? …. NO because they are completely uncorrelated.
Now in global money markets there are lots of sectors, industries and asset classes that are both correlated and uncorrelated, it is your job to pick wisely to develop a solid diversified portfolio that is immune to the risks of correlation or in fact take advantage of it.
Any serious investor or trader would have read and understood the MPT or Modern Portfolio Theory based around Correlation Diversification using the Correlation Coefficient formula, … let’s call this CC or I’m gonna get tired. Using a mathematical base ratio called “CC”, we can determine just how correlated 2 assets are on a scale of +1 to -1. +1 meaning that 2 assets will move in the same direction roughly the same time and amount, where as a -1 means the 2 assets will move in opposite direction at roughly the same time and amount, and finally a 0 means they are both unaffected by each other what so ever.
It takes a lot of work to calculate the data of a specific set of assets so I’m not going to go into that today and instead just use some basic examples so you can get your head around it all.
Imagine you enter the wonderful world of investing in equities and you have a look at your favorite companies in the US markets and decide to put half your money into Facebook and half into Twitter, sweet now your diversified…right?….NO, you are not! Until tomorrow, when Trump comes out and bans social media in the US, ironically announcing it through a tweet…. Both Facebook and Twitter stocks would plummet together as they would have a CC of almost +1 in this situation.
Now let’s say instead you put half of your money into Facebook and the other half into Google, there is still a good chance that Trumpster’s tweet may destroy half of your portfolio, but the other half may not be effected at all, and THIS Is how you properly diversify using the MPT.
A good way to diversify your investment portfolio is to consider the different sectors and find potential players with in each industry. As an example, energy, banking, retail, real estate, entertainment, and tech industry, by diversifying into each industry you are properly protecting yourself, against 1 bad egg spoiling the lot.
Ok Grizz, but what’s this got to do with Crypto?
Well, I’m sure you have seen plenty of people posting pics of their super sweet diversified portfolio pie chart of alt coins, asking for feedback or advice lately. Most of the time the replies will be something like “wow can’t believe you don’t have any (enter SH!Tcoin)” or “Needs more (enter SH!Tcoin) it’s been the best performer all year…… for me” or one of my favorites “It’s almost criminal to not have 50% of (enter SH!Tcoin) in your portfolio”
But what if I told you the whole CC of the Crypto market is dynamic, for ever changing and almost impossible to predict…well I said impossible but it’s really not that hard if you take your time to get your head around it.
What I mean by this is at times the CC of your “Alt bags” to bitcoin can have a CC of +1.
Often it will have a CC of -1. And at times they can be anywhere in between, but rarely are they at 0.
Woo woo woo what are you getting at Grizzly…
What I’m getting at, is your “diversified” crypto portfolio is actually considered super risky because of the fluctuation of the CC on an almost daily basis. You simply can’t track it, especially if you didn’t even understand what I have been explaining here this whole time.
The price of almost every altcoin at any given time is correlated in some way to the movements in bitcoin.
If bitcoin pumps, alts dump, this is a -1 CC….. if bitcoin dumps, alts can dump too and that’s a +1 CC. If BTC goes sideways alts can sometimes move freely or recover from the beating they just had, making them more like +/- .25 or so.
In other words, your portfolio is not diversified and is in fact almost 80–90% of the time correlated to the base asset class, and not in a good way unfortunately. It is because of this correlation from the base asset in crypto (bitcoin/sats) that the only way to beat the market is to pick the right time to get in or out as the correlation is changing. If you are a “hodler” there is a good chance you have probably been holding your position through so many changes in CC you are most likely sitting anywhere from a -20 to a -90% loss of your base asset and in some cases even more.
Some of you are probably still confused with what I’m saying and that’s because you’re still looking at the USD value of your altcoins instead of the BTC or SAT value which is actually the base currency of the Crypto market due to an arbitrage triangle. But do not worry it will all make sense soon, that is something I will explain in the next 2 parts of this series.
For now…peace
