Diversification is one of the fundamental principles of investing that helps reduce a portfolio’s risk. When building a cryptocurrency portfolio, managing risk in this volatile market is essential to hedge against risks. So, how does one pick winners and losers among the thousands of digital tokens available?
Also, the market’s interconnection in terms of prices and volatility is essential for measuring and managing risk.
Deciphering the connection
Prices across cryptocurrencies tend to move in a similar direction and remain sensitive to volatility. According to a study by the Federal Reserve Bank of Chicago, digital assets remain extremely sensitive to shocks in the market.
“The connected-ness index values I compute using different specifications, sample sizes, and time windows range between 86% and 97%,” wrote Filippo Ferroni, a senior economist at the Chicago Fed.
“From a risk-management perspective, this also suggests that creating a diversified portfolio of cryptocurrencies would be tough.”
Most of the variations in the prices of cryptocurrencies resulted from the market’s spillovers. Even standard shocks influence the market. For instance – The downward trend in 2018 and the upward trend in 2020. And now, the ongoing conflict between Russia and Ukraine.
Breaking it down
Consider the table below – It highlights average directional spillovers from one cryptocurrency to others. It measured the extent to which the fluctuations in the price of a digital currency influence, on average, the cost of other digital currencies.
Source: Chicago.fed
The currency that generated the most significant directional spillover was Bitcoin. Specifically, about 10% of price fluctuations in other currencies originate from changes in the price of Bitcoin. Similar systemic importance was attributed to Cardano and Ethereum, representing a nontrivial fraction of the total cryptocurrency market cap.
This suggests that directional spillovers over the entire sample period have been relatively low. Each currency individually had a small spillover to the prices of other currencies but was taken together. These spillovers were more significant than the “idiosyncratic shocks” to each coin.
Crypto-prices dropped this year with the Fed raising rates and the Ukrainian war weighing on investor sentiment. Bitcoin and Ether fell 20% and 10%, respectively. Few tokens bucked the downward trends when the Coronavirus pandemic in 2020 and Beijing’s crypto-ban in 2021 wreaked havoc on the crypto-market.
Nonetheless, a few digital assets did remain solid enough to record surges, despite BTC’s price correction in 2022.