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How to Manage Risk in Your Crypto Portfolio

How to Manage Risk in Your Crypto Portfolio

Learn how to measure and manage risk across your crypto portfolio.

Many investors laser-focus on potential returns when deciding what crypto assets to buy or sell. But, of course, predicting prices in any market is notoriously tricky. Instead, you may consider optimizing the other side of the coin – risk. Anyone can significantly reduce risk with simple moves and improve their risk-adjusted returns.

This article examines how to measure and manage risk in your crypto portfolio to maximize your risk-adjusted returns over time.

What is Risk Management?

Risk management is a critical factor when making investment decisions. A negative return will hurt long-term performance more than the equivalent positive return. If you invest $100, lose 50% ($50), and then see a subsequent 50% increase, you’ll still be down 25% ($75). You’d need a 100% gain to recoup the entire 50% loss!

But risk management is about more than avoiding losses. For example, while older investors approaching retirement may want to minimize volatility, younger investors with decades ahead of them may view a lack of volatility as a risk (opportunity cost). Meanwhile, day traders may measure risk by their time in the market or the amount of leverage they use.

Different Types of Risk

Categorizing risks into buckets can help you better understand and address them. By breaking risks into more digestible components, you can more effectively prioritize, mitigate, and accept the risks based on their nature. The structured approach can also help you streamline decision-making and avoid many fallacies impacting traders and investors.

Most risk falls into two high-level categories:

  • Systemic Risk – Systemic risks are inherent to every asset in a market. For example, new crypto regulations could depress the entire crypto market – not just a single asset. Some high-profile crypto assets like Tether could also pose a systemic risk for the whole market.
  • Non-systemic Risk – Non-systemic risks apply to a single asset. For example, a newly launched decentralized finance protocol may involve the risk of a faulty smart contract. These risks are specific to the protocol and won’t affect other crypto assets.

Then, you can further break these categories down into subcategories. For example, regulatory and interest rate risks are systemic risks, while business model and liquidity risks are non-systemic risks. By categorizing risks into these buckets, you can begin to prioritize them and develop effective strategies to mitigate them.

How to Measure Risk

Risk management relies largely on statistics to assess the relative risk of different assets or combinations of assets in a portfolio. Quantifying risk with a number makes it easier to compare risks and develop precise strategies to mitigate them. For example, a beta coefficient makes it trivial to sort assets by their volatility and assess their relative risk.

Some of the most popular ways to measure risk include:

  • Standard Deviation – Standard Deviation measures the historical volatility of an asset relative to its rate of return. As a result, you can see how much of an asset’s current return deviates from its expected historically regular returns.
  • Sharpe Ratio – The Sharpe Ratio removes the risk-free rate of return from the overall expected return of an asset and divides the remaining return by the asset’s standard deviation. This ratio enables you to compare returns per unit of risk.
  • Beta Coefficient – The beta coefficient measures an asset’s systemic risk relative to a broader market. An asset with a beta of more than 1.0 is more volatile (and risky) than the broader market.
  • R-Squared – R-squared is a statistical measure showing the percentage of an asset’s price movement that movements in a benchmark index can explain. In other words, you can determine if the asset is risky or if the market is just volatile.

Of course, these are just some of the most prevalent risk metrics. You can also turn to more advanced techniques to gain deeper insights. For instance, Monte Carlo simulations model various outcomes in a process where there’s uncertainty, helping you see a probabilistic range of returns. Ultimately, the metrics depend on your sophistication and goals.

Strategies to Mitigate Risk

Risk management isn’t always intuitive, so let’s start with a simple example using dice. Rolling a single die produces a flat outcome since each number has an equal probability. But when you roll two dice and take their sum, you’re more likely to roll a seven than a two or twelve. And when you add more dice, the distribution becomes even more bell-shaped.

Most risk management strategies begin with this kind of diversification. As you add more assets to your portfolio (like dice in our example above), your overall returns will gravitate toward the average market return (producing a more bull-shaped distribution). The extremes – like experiencing a considerable drop – become less likely as you add more assets.

But, while dice don’t correlate to each other (rolling a six doesn’t influence the odds of rolling another six), crypto assets often have strong correlations. If the price of Bitcoin or Ethereum drops, it impacts the entire cryptocurrency market. So, crypto diversification depends on building a portfolio of non-correlated assets.

Some more high-level tips for diversifying and mitigating risk include:

Combine established crypto with newer projects and concepts. For example, you could hold Bitcoin, Ethereum, and invest in promising initial coin offerings. That way, you can benefit from the more significant upside potential of these smaller projects without tanking your entire portfolio if one of them fails.

Invest in different areas of the crypto market. For instance, you might invest some capital in decentralized finance protocols to generate income, speculate on non-fungible tokens, and invest in metaverse or crypto gaming tokens. That way, trends impacting one market won’t influence your entire portfolio.

Consider indirect exposure via crypto stocks and exchange-traded funds (ETFs). For instance, you can invest in crypto exchanges or Bitcoin ETFs to reduce exposure to cryptocurrencies on the blockchain and potentially benefit from broader trends than specific assets (e.g., investor appetites for crypto in general boosting valuations).

Strategies to Mitigate Risk
Looking at the correlations between different crypto assets can help you build a portfolio where the price movements of one coin don’t impact the others. Source: MacroAxis

Suppose you’re interested in more granular risk management techniques. In that case, you might consider tools like MacroAxis’ Cryptocurrency Correlation tool or CoinMetrics’ Correlation Charts to find non-correlated crypto assets and build a portfolio. But, of course, you must also ensure that these assets meet your fundamental or technical criteria for inclusion first.

The Bottom Line

Risk management is a complex topic, but it has some easy-to-understand takeaways. In particular, you can dramatically cut down your risk without sacrificing returns through diversification. But, at the same time, it’s essential to step back and consider your risks and risk tolerance levels beforehand.

If you invest in crypto assets, ZenLedger can help you organize your transactions for tax time. After connecting your wallets and exchanges, the platform automatically imports your transactions, computes your overall capital gain or loss, and generates the tax forms you need to file. That way, you can focus on what matters rather than tedious paperwork.

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This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.

Justin Kuepper