Hundreds of investment strategies exist. Some mitigate risk, while others embrace it. Some punish impulsive behavior, while others reward it. But what you’ll eventually discover is that all strategies appear in two forms: passive or active.
Passive investing is essentially a buy and hold strategy. Investors use fundamental analysis to examine stocks or cryptocurrencies and their quality. They then buy a select few and forget about everything. The investment may last for a year or two, but the person holding the assets will never touch their portfolio. Sure, they might add more capital or compound profits but won’t do anything more. Their role always remains passive.
Active investing is the polar opposite. This type of investing means constantly observing market dynamics and the evolution of a financial cycle. Active investing involves keeping strict risk profiles, experimenting with different asset types, and most notably, portfolio rebalancing.
Portfolio rebalancing is a simple act. We realign our portfolio’s allocations to keep risk at bay, take profits where needed, and invest in meaningful new trends. But how does it fare against passive investing?
Rebalancing is nothing more than maintenance. We maintain cars, appliances, homes, and even our health. Why not apply the same level of thoughtfulness to finances? After all, volatility forces us to manage our investments.
Take the crypto market for example. In an average four-year market cycle, the market goes through heaps of changes. Decentralized oracles are all the rage in March. In April, everyone’s eyes are set on L2 scaling solutions. Then a month later, a new arrival like cross-chain bridging protocols pop up and temporarily catches the market’s attention.
The market punishes those who remain passive because the market is dynamic.
Trends spring up like mushrooms after rain, but they can wither away just as easily. As a result, investors must keep their portfolio in check and periodically rebalance it. They otherwise risk the chance of decimating their capital.
Certain assets are only good for a certain amount of time, and there is nothing wrong with that. We rebalance to reap the rewards and negate the risks of holding onto an asset for too long.
How Does Portfolio Rebalancing Work?
How we rebalance and spread allocations depends on the market and our personal risk appetites.
Here’s a classic example of what steps the average crypto investor would take in an uptrending market:
Examine the market
Set your personal risk profile
Distribute capital into different assets
Allocate capital evenly
Take profit on assets that outperform the market
Rebalance portfolio so that new profits move into assets that lag behind
Rinse and repeat
A case study conducted by Shrimpy confirmed that rebalancing works for downtrending markets as well. When we looked into the 2018 bear market and compared rebalancing to HODL, our team discovered that 78.67% of portfolios which rebalanced outperformed the buy and hold strategy.
Six-asset portfolios utilizing a daily rebalancing period outperformed identical buy-and-hold portfolios by an average of 21.6%. Portfolios with more than six assets have delivered even better results, and as the data revealed, daily rebalancing proved to be the most efficient timeframe.
Types of Rebalancing
Two popular rebalancing strategies exist: periodic and threshold rebalancing.
Periodic (calendar) rebalancing involves setting predetermined time intervals at which one examines the market and rebalances their portfolio accordingly. Investors can rebalance at the following intervals:
Deciding which interval to use falls to personal preferences. Full-time investors have the leisure of rebalancing portfolios almost every single day. Those with limited time can only afford to mix allocations once a week or perhaps on a monthly basis.
Shorter intervals are often far more suitable for experienced investors or those relying on algorithmic trading services like crypto trading bots. In certain cases, longer intervals fare better for the average investor and expose them to less stress.
Transaction costs are another factor worth keeping in mind when determining rebalancing intervals. If one’s portfolio consists exclusively of Ethereum-based cryptocurrencies, gas fees will negate the positive effects of daily or even weekly rebalancing.
Threshold rebalancing involves giving assets or asset-types target weights for allocation and tolerance ranges. Assets within a portfolio can’t deviate from either of the two metrics.
For example, let’s say we have a four-asset portfolio made up of Bitcoin, Ethereum, Solana, and Avalanche. This portfolio enforces an even allocation of 25% for each asset. All four assets have a tolerance range of ±3% from which they can’t deviate.
If Ethereum suddenly rises in value it will disrupt this threshold rebalancing strategy. We then have to take profits from Ethereum and allocate the capital into the remaining three assets so that all return back to their initial 25% target weight.
Or perhaps Bitcoin falls down 5% while Solana jumps up 5%. The investor will take his Solana profits to buy the Bitcoin low and keep his target weights in check.
Such a strategy ensures that investors take profit when needed. It also provides a system that mitigates losses when an asset lags behind the market by allocating more capital. Sell high, buy low. That’s the power behind threshold rebalancing.
Tips for Rebalancing Cryptocurrencies
Rebalancing a crypto portfolio is somewhat different from rebalancing stocks, bonds, or other asset types. There are several extra factors to consider as rebalancing digital assets requires a special approach. Moreover, certain rebalancing steps work differently, like determining allocations.
Tip #1. Determine risk level with market capitalization
Investors who are not sure how to allocate their capital should rely on market capitalization. Market capitalization is a safe indicator of an asset’s risk profile. Cryptocurrencies with a large market cap require more capital in trading volume to gain or lose value. Likewise, small or medium caps require less.
Let’s say we’re a risk-averse investor. We want to allocate a larger portion of our holdings to large market cap assets for the stability they provide. But at the same time, we don’t want to completely miss out on small cap gems that are currently trending, so we decide to dedicate a small but still significant amount of money to this group.
What do we do? We hop onto CoinMarketCap and quickly glance through their list to get a good understanding of each asset’s market cap.
With a three-asset portfolio we can allocate capital into two large caps and one small cap by following a 40/40/20 proportion. For example, for a $10k portfolio we allocate $4000 into Bitcoin, another $4000 into Ethereum, and $2000 into a project such as Alchemix.
Tip #2. Use lax tolerance ranges
Let’s say we run into a problem. Our small cap project outperforms the market, and due to a strict tolerance range, the threshold rebalancing strategy we’re utilizing forces us to take profits way too early. We miss out on potential gains and suffer the consequences.
What do we do to prevent this from happening in the future? We set a wider tolerance range. Rather than meddling with 2%, 3% or 5% ranges we decide to use 10%. Or better yet, we implement a special tolerance range specifically for the low market cap asset. By doing so, we fix a common problem in the crypto market: taking profits too early.
Tip #3. Automate your portfolio
Crypto is fast. Way too fast for some. If you are not a full-time trader, you won’t have time to manage your portfolio as efficiently as a person who spends all their time staring at charts. Knowing that there’s a loser for every winner, it becomes evident that investors need to up the ante.
Algorithmic trading accounts for a significant portion of today’s trading volume. Data shows that 10% of hedge funds from the U.S. and Europe automate up to 80% of their trading value. It’s no surprise that automation became an alluring option for crypto investors as well.
You don’t have to rebalance your portfolio manually anymore. Modern solutions provide ways of automating cryptocurrency portfolios with only a few clicks. Doing so allows you to spend less time in the market, avoid the side-effects of investing in a 24/7 market, trade with higher precision, and avoid repetitive tasks.
Shrimpy is an automated portfolio management tool that provides rebalancing services and connects dozens of exchanges with your account, from which you can execute trades seamlessly. Check it out if you wish to see how rebalancing works and see the magic yourself.
Need more tips? Check out the following resources:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.