Crypto portfolio rebalancing: Manage risk and maintain diversification
Do you remember making your first investment? Were you then even aware of the skills it would take and the risks you would face? For most investors, the answer is no.
While acquiring skills is a task you have to complete on your own, to manage risk, you can use the help of different tools.
One of the best tools for that tricky endeavour but also maintaining diversification is portfolio rebalancing.
What portfolio rebalancing is, how and when it's implemented, as well as what benefits and drawbacks it has will be explored in this article.
So, if you are eager to embark on your crypto portfolio rebalancing journey, make sure to keep reading!
What is portfolio rebalancing?
The rebalancing of a portfolio, be it a traditional or a crypto portfolio, involves buying and selling assets within your portfolio to maintain the original asset allocation and level of risk.
The return and benefits rebalancing can bring are best visible in the long run, so it’s not a one-time-use type of tool.
In order for a portfolio to be eligible for rebalancing, it must be diversified, meaning it must consist of more than one asset.
How does crypto portfolio rebalancing work?
Rebalancing is fairly straightforward to implement. Think of it as a more advanced version of the buying low and selling high approach.
Buying low and selling high can be very affected by an investor's emotions and psychology. In rebalancing, both are taken out of the equation.
So, how does rebalancing work in practice?
The easiest way to explain rebalancing is by imagining a diversified asset portfolio. Assets, in this case, will be cryptocurrencies.
Since each asset is priced differently, the percentage of an asset within a portfolio should be calculated in fiat or a base currency. In other words, if you had $1000 to create the portfolio, you'd buy $500 worth of BTC, $250 worth of SOL, and $250 worth of AVAX.
As the market moves and prices go up or down, the allocation of your portfolio changes. This is where rebalancing comes into play.
When it comes time to rebalance the portfolio, assets are bought and sold accordingly so that the target allocation is again achieved. After the rebalancing is complete, your portfolio should again consist of 50% BTC, 25% SOL and 25% AVAX. Simple, right?
Why is portfolio rebalancing done?
Like it or not, the crypto market is a place full of volatility. Because of this, inexperienced investors tend to be more exposed to risk. In order to keep the risk at an acceptable level, monitoring and rebalancing a portfolio is crucial.
While managing risk is rebalancing's main benefit, it isn't the only one.
Other rebalancing benefits:
- Taking advantage of price fluctuations - The same way an asset's price can drop, it can also spike. With rebalancing, the gains from a price spike are distributed across the other assets in the portfolio. If the price that spiked were to then drop to its original state, you still earned a positive return thanks to rebalancing.
- Becoming a more disciplined investor - Very few people are able to remove their emotions from the investing equation. This can lead to them making decisions based on a temporary state of the market or even their own predictions of where the market will go. Investors who stick to rebalancing put their focus on their portfolio and not the market. Also, they avoid falling victim to FOMO if an asset's price unexpectedly spikes.
- Being able to let go of "winners" - While it might seem like the most logical, allowing one asset to over allocate in your portfolio over the long term just because it's on an uptrend is risky business. If the price of that asset starts going down, your losses would be quite significant since your portfolio is highly dependent on the success or failure of that single asset. This cannot happen in a portfolio that is regularly rebalanced using the buy low sell high approach.
After being presented with so many rebalancing benefits, you might be thinking, "Where is the catch, and what are the drawbacks of rebalancing?"
While there aren't many, it's only fair we go over them.
- Cutting short an asset's bullish trend - In the rare case you rebalance too early and thus sell an asset that is still on an uptrend for an asset that will drop in price soon after, you will suffer losses.
- Paying high fees - When selling and buying assets during portfolio rebalancing, you need to pay transaction fees to cryptocurrency exchanges. If your portfolio doesn't have a high value, the transaction fees might cancel out your gains.
- Having to rebalance frequently - Depending on how volatile the market is, you might need to rebalance very often, which can be expensive and, if done manually, very time-consuming.
- Fulfilling tax requirements - You may be required to pay capital gains taxes after selling an asset to rebalance a portfolio. Whether this is the case depends on your country or region.
The most common rebalancing types
There are different rebalancing types an investor can implement. Below, we will cover the most common ones:
The most basic rebalancing type is called periodic rebalancing. With periodic rebalancing, your asset allocation is adjusted on a predetermined time interval - every hour, day, week, month, etc.
Due to the rapid price fluctuations of cryptocurrencies, this interval is usually shorter than for other asset classes.
As periodic rebalancing is very simple to understand, it is great for beginner cryptocurrency investors. But, it's important to note that when using it, asset allocations are not changed even if the portfolio is out of balance until the rebalancing time comes.
With threshold rebalancing, your portfolio's asset allocation is adjusted when an asset's value crosses a particular threshold.
For example, your portfolio of 50% BTC, 25% SOL, and 25% AVAX has a threshold of ± 10%. If the percentage of any asset within the portfolio rises or drops by 10%, it's time to do rebalancing.
If the threshold is not reached, then there is no need for rebalancing.
This type of rebalancing is great for investors with smaller portfolios who don't want to spend loads of money on transaction fees which often come as part of frequent periodic rebalancing.
A combination of periodic and threshold rebalancing, hybrid rebalancing is the best of both worlds. With this type of rebalancing, an investor would adjust the portfolio allocation on a schedule but also when an asset's value crosses a particular threshold.
How portfolio rebalancing is done
This approach involves rebalancing your portfolio yourself without any external help.
When rebalancing is necessary, you will sell and buy assets within your portfolio in order to meet the target allocation. This could prove to be a bit tricky as you'll need to do your best to execute transactions as close together as possible.
Another thing that will be your responsibility in this process is logging each transaction. This is required so you can later accurately compare investment performance and know what your capital gains were for tax purposes.
If you prefer not to get involved in the rebalancing process, there are investment advisors, companies, and tools that can do the rebalancing for you automatically. Thematics , for example. They are essentially theme-based crypto bundles, that thanks to their periodic auto-rebalancing will keep your portfolio diversified even in volatile markets, distributing risk across assets and bringing profit from asset price fluctuations. In this whole process, you don't even have to lift a finger, but you still get to enjoy peace of mind as well as save time.
Portfolio rebalancing is an effective tool to manage risk and have more profit in the long run. An investor can benefit a lot from rebalancing as it allows them to become more disciplined, learn to use price fluctuations to their advantage, and see past the current state of the market.
Which rebalancing type is best for you will depend on your goals and expectations. Still, whichever type you go for, you can rest assured that with it, your portfolio has a good chance of performing well in the long run.
Do you rebalance? And if yes, what is your favourite rebalancing type? Let us know on Twitter !
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