When you first invest, the assets inside your portfolio will likely be proportional – each asset will have the same value. But as your crypto investments go up, you’ll notice there’s no balance any more. The dollar value of one asset might grow extremely high, causing it to represent up to 80% of your total capital.
Whenever your portfolio isn’t balanced anymore, you should rebalance it to optimize your performance. But what are the pros and cons of rebalancing a crypto portfolio and should you apply this strategy?
What is Portfolio Rebalancing?
Portfolio rebalancing means adjusting the weightings (allocations) of your portfolio. Assets move up and down in value, which disturbs your original weightings. The goal of rebalancing is to balance the weightings in order to optimize your portfolio.
Rebalancing optimizes a portfolio by selling assets that have moved up and redistributing funds into assets that haven’t moved yet. If a random altcoin jumps 300% in value, you might want to take profits and secure your win. But where should the profits go? You move them to an asset that hasn’t moved much – or at all. This could be a stable giant such as Bitcoin or a volatile altcoin such as Ethereum.
Rebalancing a portfolio calibrates your risk level by adjusting your holdings and bringing them back to their original levels. You take profits where needed and stop losses in their track. It also creates room for more profits and perhaps newer assets. Remember, it’s all about taking profits, buying low, and selling high.
Advantages of Crypto Portfolio Rebalancing
The primary advantage of crypto portfolio rebalancing is limiting your exposure to risk. By rebalancing, you minimize the minimum and maximum amount of money you can win or lose. Whenever an asset grows higher than it should, you sell it to make more room for other assets. And on the losing side, it forces you to sell assets that don’t perform well – you then reinvest those funds into better assets.
Rebalancing also introduces diversification. If you win too much money, you can optimize your portfolio by redirecting capital to more assets. And the more assets you have, the lower your risk exposure. With enough assets, the effects of a losing asset are negligible compared to your total capital.
If you regularly rebalance, you’ll find another advantage: you don’t fall in love with assets. An asset and its use case might sound good on paper, but if it doesn’t attract customers and create demand there’s no reason to invest. You can wait a month or two or even a year. But if the asset fails to generate profits, you have no reason to hold it anymore – you hold investments, not emotional baggage. That’s when you pull an Old Yeller and say goodbye to your precious coin.
For me, the biggest advantage of rebalancing is actively changing allocations. I always conduct fundamental analysis to find the right coins. But I’m so confident in my picks that I fail to consider the performance of my assets. I don’t care about short-term price movements because I think about where the asset will be in five years. But even though I invest for the long-haul, I miss out on valuable gains in the interim. It hurts no one to optimize an already perfect strategy.
Disadvantages of Crypto Portfolio Rebalancing
The main disadvantage behind crypto portfolio rebalancing is that it only has one ace up its sleeve: momentum. The hypothesis is that high-performing assets go down and low-performing assets go up. I sell the former to buy the latter and earn infinite money. But I’m no Albert Einstein and this isn’t gravity.
There’s no invisible force that pulls an asset down once it goes up and pushes it up after falling down. If I sell an asset, there’s the risk that it will continue rising in value, forcing me to lose money on a good asset. A more heinous outcome would be that the reinvested funds go toward an asset that hasn’t moved yet and now does – but in the wrong direction.
Portfolio rebalancing only brings me value if assets that went up lose value and vice-a-versa. If the opposite happens, I lose both opportunity and money. I can sell Chainlink on its run to $1,000 thinking XRP will finally move above $2.
You should only sell assets when their narratives fall apart. Is your token no longer DeFi’s leading lending product? Sell it. Has your NFT protocol not followed its roadmap? Sell your JPEGs. Has your token’s network gone haywire and destroyed its TPS? Sell your SOL.
Transaction costs represent another major hurdle to portfolio rebalancing. If you rebalance frequently, you will spend a noticeable amount of money on trade fees and transaction costs. Frequent trades might also not favor certain investors. Those from barbaric jurisdictions that charge taxes on every trade might want to avoid rebalancing.
Popular Crypto Rebalancing Strategies
Crypto portfolio rebalancing offers many advantages but it also has its flaws. If the pros offset the cons, you might want to go ahead with rebalancing. But which rebalancing strategy should you use? The section below features a list of popular rebalancing strategies for your crypto needs.
Threshold rebalancing is a rebalancing strategy where you apply tolerance bands to your holdings. An asset has an assigned allocation percentage and can not deviate excessively. You may allow the asset to move 10% up or down, but you’ll buy or sell it as soon as the price change breaks 10%.
A popular crypto investing plan is holding Bitcoin and Ethereum. Investors tend to hold one half of their portfolio in Bitcoin and the other in Ethereum. If they wish to ensure a 50/50 split forever, they can incorporate a threshold rebalancing strategy. This would involve setting a 5% tolerance band so that the portfolio can maximally deviate to a 55/45 split. If one asset outperforms, the investor will sell it to buy the other asset.
The effectiveness of threshold rebalancing depends on the market, but also on the width of the threshold. How your strategy turns out depends on whether you apply a low or high threshold strategy. Both types come with a list of pros and cons.
- Less volatility
- Lower returns
- Higher transaction costs
- More frequent rebalancing
- Threshold is almost never breached
- Higher volatility
- Higher returns
- Lower rebalancing costs
- Less frequent rebalancing
- Threshold may be breached from time to time
Constant Proportion Portfolio Insurance (CPPI)
Constant Proportion Portfolio Insurance (CPPI) is a rebalancing strategy based on the premise that risk increases along with wealth. To protect your capital against risk, you need to allocate a portion to cold hard cash – or stablecoins. Doing so ensures that your wealth is protected and that your portfolio is not subject to extreme volatility.
If I hold all my capital in crypto and the market breaks records, I’ll see a nice boost to my portfolio. But a simple retrace is enough for my portfolio to bleed and experience a 20% fall. If I want to protect my capital and ensure profits, I need to exchange a portion of my tokens for stablecoins.
Let’s say I have $100,000 in crypto and another $100,000 in Tether (USDT). If the market crashes 30% it’ll only affect my crypto holdings, leading to $30,000 in losses. That means my total portfolio will be worth $170,000. If all my money was in crypto, I’d lose $60,000 and own $140,000. But by holding stablecoins, not only do I avoid losses, but I also gain the opportunity to rebalance my portfolio by reinvesting my stablecoins into crypto.
Calendar rebalancing is a strategy that focuses not on allocations or value, but time. All you need to do is determine a time interval at which you want to rebalance. You can rebalance on a daily, weekly, or monthly basis. The frequency at which you change your portfolio depends on similar factors mentioned in threshold rebalancing.
Higher frequency rebalancing incurs higher transaction costs but leads to lower portfolio drift. Lower frequency rebalancing offers lower transaction fees, but at the cost of higher portfolio drift. Which option you choose depends on how liberal your portfolio should be with drifting from its original allocation.
Calendar rebalancing is much easier compared to the previous two strategies. You don’t need to calculate risk nor monitor tolerance bands. Your only job is to rebalance your portfolio every week or month.
Without the help of any tool, you’ll have to rebalance your portfolio manually. If you want to make your life easier, you should automate your rebalancing experience. For automated rebalancing I recommend Shrimpy – an automated portfolio management platform that helps you track and rebalance your portfolio, backtest trading strategies, copytrade great traders, and many other things.
If you want to learn more about rebalancing portfolios, I recommend reading the following articles: