The cryptocurrency market is in perpetual motion, meaning that no single asset can expect to retain its original value for too long. Such volatility places the portfolios and, therefore the potential profits of investors, at risk. In order to avoid such loss of value arising from price dynamics, investors resort to a tactic called portfolio rebalancing.
Portfolio Rebalancing Explained
If portfolio rebalancing is to be explained in short, it is the redistribution of available assets through subsequent purchase and sale operations with the aim being their return to original weightings within the portfolio.
A simple imaginary case can be taken to illustrate the approach to portfolio rebalancing on a simple example.
In the example, an investor has a portfolio containing an even distribution of coins, including BTC at 50%, and 10% of TON, ETH, ADA, DOT, and BNB tokens, respectively. Some market movements then take place, which result in TON rising in price in comparison with the ADA token in the portfolio. TON now occupies a 15% allocation within the portfolio, so ADA will become 5%. In order to rebalance the portfolio, the investor will sell some TON tokens and purchase more ADA in order to return the distribution to the original 10% share.
Rebalancing makes sense if there are multiple assets in the portfolio and each is priced differently. As such, the redistribution is based on a percentage ratio in terms of the original investment in fiat.
In another example, if the investor has $1,000 to invest and will be buying the aforementioned digital assets, then they can spend $500 on BTC and allocate $100 for purchasing each of the remaining tokens.
The ongoing market fluctuations in the market result in asset price swings, forcing investors to constantly purchase and sell some of their assets in order to maintain the initial ratio. The idea is to maintain the original value of the investment, or $1,000 in our example, meaning that the assets will have to be converted into the base ratio for ease of calculation.
The purpose of portfolio rebalancing is to maintain a risk-to-reward ratio on a stable scale to counter volatility, thus mitigating possible risks, which can include investments in riskier assets like BTC. Portfolio rebalancing is a long-term approach to investing and is not a means of reaping profits in the short run.
Factoring in for Portfolio Rebalancing
There are two main factors that should be considered before investors decide to resort to portfolio rebalancing, and the timing for doing so.
Market conditions are the first factor, as they will determine the likelihood of future price swings for the assets in the portfolio. Some assets will be performing better than others under certain conditions, meaning investors should adjust their allocations accordingly.
Risk tolerance is the second factor to consider together with the ultimate purpose of the investment. If the investor decides to take on the crypto market with a long-term approach in mind, then they should factor in a number of issues, such as potential fees, taxes, all of which can reduce potential earnings. Low risk tolerance may also require more frequent rebalancing of the portfolio, depending on market conditions.
Rebalancing Crypto Portfolios
When opting for portfolio rebalancing, the first step is to determine the allocation. The latter will be in percentage terms. But before doing that, all available and future assets must be converted into a base currency, like the US Dollar. Then the assets are summed up and their allocation calculated based on their assigned ratios in percentage terms.
Sometimes, investors already have assets in their portfolios and wish to rebalance them. In the following example, the investor wishes to have 70% BTC, 20% TON, 7% BNB, and 3% USDT, however, current allocation stands at 92.2% BTC, 5.8% TON, 1% BNB, and 0.9 USDT. Ergo, the investor will have to sell some BTC until its allocation in percentage terms goes down to 70% and then stock up on the remaining
Before taking on asset rebalancing, investors should choose an appropriate strategy. Among the ones available on the market, it would be proper to single out the following:
Threshold rebalancing – this strategy involves adjusting assets up or down once their allocation crosses a certain set threshold in percentage terms.
Periodic or calendar – periodic allocation requires investors to rebalance their portfolios after a certain period of time, or at set dates. The advantage of the given approach is ensuring low portfolio drift.
Hybrid – under this approach, the portfolio is rebalanced based on a combination of threshold and periodic strategies.
All rebalancing strategies can be applied both manually or automatically, since virtually all exchanges and specialized portfolio management services offer bots and special features to facilitate and automate the process of portfolio rebalancing based on real-time market data.
Pros and Cons of Portfolio Rebalancing
Just like any other strategy on the cryptocurrency market, portfolio rebalancing has its advantages and disadvantages.
Risk mitigation against market volatility and potential resulting losses.
Diversification of portfolios to balance potential gains by leveraging the qualities of various assets.
Asset distancing, which allows investors to have a sober outlook on all types of assets without bias towards any specific one.
Allocation management, which allows for sound fundamental analysis to identify potentially promising coins.
Momentum as a risk, since high-performing assets and low-performing ones will undermine each other and the relation of their earning potential is dependent on market conditions.
Inverse relationship between asset prices, meaning portfolio rebalancing yields benefits only if high-performing assets lose value, and if the opposite happens.
Transaction costs are an inevitable expense that investors will incur when frequently rebalancing their portfolios.
Portfolio rebalancing is an important element of crypto market presence, since it allows investors to manage their assets based on their price performance. The versatility of the approach through manual or automated mode, and the many strategies available, make portfolio rebalancing a routine element of crypto trading.