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Motivation

The goal of any good asset allocation is to minimize risk whilst maximizing profit. In this post, I am going to explain how to create a market cap weighted cryptocurrency portfolio which is constructed in a similar fashion as the big stock indexes. This is used to diversify accross mulitple cryptocurrencies and enables to invest in a meaningful representation of the cryptocurrency market as opposed to the riskier investment in randomly picked cryptocurrencies.

Diversification

There is no such thing as free lunch - except with diversification. In an ideal world (where assets correlate by -1.0) diversification is the only thing which maximizes profit whilst minimizing risk. It may sound counterintuitive at first: Shouldn't the best performing indiviudal asset outperform a combination of multiple assets? Well, not when assets correlate negatively. Let's look at the following example of two hypothetical cryptocurrencies. Crypto A performs well during the winter, whereas Crypto B performs well during the summer.

Month Crypto A Crypto B
Jan. + 35% - 10%
Feb. + 15% - 5%
Mar. + 10% - 2%
Apr. - 2% + 10%
May - 5% + 15%
Jun. - 10% + 35%
Jul. - 10% + 35%
Aug. - 5% + 15%
Sep. - 2% + 10%
Oct. + 10% - 2%
Nov. + 15% - 5%
Dec. + 35% - 10%
Average + 7.17% + 7.17%
As you can see, both cryptocurrencies have an equal performance over the whole year of + 7.17% as calculated with the arithmetic average.

Now let's assume that we create a portfolio, where we take both of the cryptocurrencies and allocate 50% of the portfolio each. The total portfolio performance is shown in the following table:

Month 50/50 Portfolio
Jan. + 25%
Feb. + 10%
Mar. + 8%
Apr. + 8%
May + 10%
Jun. + 25%
Jul. + 25%
Aug. + 10%
Sep. + 8%
Oct. + 8%
Nov. + 10%
Dec. + 25%
Average + 14.33%
Our hypothetical portfolio now has the best of both cryptocurrencies: We have a better performance over all and in each month which yields in less volatility and therefore less risk. That's the power of diversification!

Comparison to Stock Indexes

A stock indexes goal is to accurately represent a certain segment of the market and create a benchmark for this certain segment. To fulfill these requirements, most of today's equity indexes are weighted by market cap.
Market cap. weighting means that each individual asset is represented relative to it's market capitalization in the total market capitalization of the whole portfolio. The following table illustrates this in a simplified example:

Stock Market Cap. Weight
Stock A 130 B$ 33.7%
Stock B 215 B$ 55.9%
Stock C 40 B$ 10.4%
Total 385 B$ 100%
Each individual stock's weight is calculated by the respective amount of the individual market capitalization to the total market capitalization of all stocks in the portfolio.

The popular S&P 500 index represents the largest 500 US companies weighted by their floating (this means all publicly held stock only) market capitalization.

Portfolio Construction

After we've decided to construct our market cap weighted portfolio we first need to decide, which segment of the market we want to replicate. Traditional stock portfolios differentiate between Large Caps, Mid Caps and Small Caps among other segments such as growth or value stocks. Large Caps are companies with the highest market caps whereas Small Caps are companies with lower market capitalizations. The absolute threshold differentiates from index to index and from market to market.

This approach can be used analogous on cryptocurrencies: Large Caps are the biggest - let's say top 30 - cryptocurrencies and Small Caps are the ones with less than 100M$ market capitalization.

Creating a Large Cap Cryptocurrency Portfolio

To put this into action, we want to build our cryptocurrency portfolio of the top 5 coins. First we need the current market cap of the desired cryptocurrencies:

Symbol Market Cap.
BTC 159.8 B$
ETH 76.0 B$
XRP 31.5 B$
BCH 28.4 B$
EOS 15.8 B$
This results in a total market cap of 311.5 B$ for the top 5 cryptocurrencies as of May 2018. To get each individual cryptocurrencies weight in our portfolio, we'll just divide the individual market cap by the total market cap. For Bitcoin for example:
(159.8 / 311.5) * 100 = 51.3 %

This yields to the following allocation:

Top5CryptoAllocation

Using the Cryptocurrency Portfolio Allocation Tool

To simplify the process of portfolio allocsation, I've created a simple tool which directly pulls the current market cap data and then calculates the respective weights of the selected cryptocurrencies. The tool can also be used to rebalance your portfolio from time to time.

Rebalancing

Rebelancing a market cap weighted portfolio is not necessary as long as the contained assets stay the same. If the value of any cryptoccurency in the portfolio increases, the market cap and the weight in the portfolio increase accordingly and vice versa. Rebalancing is only necessary if the composition changes and can be calculated according to the initial portfolio planning.

Backtesting the Top 5 Portfolio

I have allocated a Top 5 Portfolio for each month ranging from May 2017 to May 2018. The data is from the historical snapshots of coinmarketcap.com and resembles each first week of the month.
output_M0XkaN

As you can see, the composition varied almost month to month. That's why periodic rebalancing would be necessary. I won't cover a manual backtesting of this portfolio in this article. I decided to create a software for backtesting portfolio allocations on which I'm working right now.
I will cover this in another article which will follow soon.

Conclusion

Creating a market cap weighted portfolio is simple an well proven in the stock world. Applying this to cryptocurrencies is a simple and straight-forward way to diversify a portfolio without relying on extensive research.
Tools such as this even help you doing all the work.

Creating a market cap weighted cryptocurrency portfolio
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