Diversification is the only free lunch in Finance
This was first posted in my old Blog (23 October 2020).
“Diversification is the only free lunch in finance” [Harry Markowitz] can be taken to refer to diversification between asset classes in a portfolio (Stock, bond, gold, crypto) or within a class. By investing in multiple projects, you reduce the risk of all your investment under performing significantly. By spreading your investment between multiple projects you lock in average performance. Remember that on average the TradFi markets active investors under perform the index. So many people recommend to just buy the index and relax: “Just pick a broad index like the S&P 500. Don’t put your money in all at once; do it over a period of time.” [Warren Buffet — who dislikes crypto…]. While crypto is obviously much more risky than TradFi the benefits of diversification still hold.
Index funds are widely used within TradFi both by long term passive investors and by large value investors who appreciate the simplicity of “owning the index” when making long-term investments or short term sector plays. Shorting a particular Index fund allows an investor to place a bet on the direction of a sector of the economy without getting involved in looking at individual companies. For example, at the start of the COVID pandemic, shorting airlines while being long on logistics would have been a good investment.
For the long term investor, relying on an index fund means that you have the benefit of the wisdom of the crowds. i.e. the market is efficient, so buying everything in terms of market cap is the optimal choice. Some even argue that a whole world market cap fund is all you need.
However, looking at the crypto market caps, many would argue that the market is not yet efficient and there are some crypto opportunities are miss priced. This means that use of an index that is more selective than “x% of everything available” is a good idea.
The figure below shows the relative price performance of the $DPI index fund value and the performance of the component protocols. This shows that as expected, the fund returns approximately average performance with the worse performing tokens being partially offset by those that had better performance.
So, by holding an index fund you can be exposed to the underlying passive gains of the selected tokens and any that are added to the index over time as the market changes. By holding the fund, you are relying on the market valuations, and index methodology, to secure performance equal to the index. This requires much less effort, attention, skill, and transaction costs compared to an active trader. As a bonus, you get many fewer transactions to include in you annual tax returns.
So, for many people use of a passive index fund may give them the long term exposure to a sector, with protection against significant changes in the market composition as new projects grow. All this with minimal attention required.
This blog is part of a planned series on diversification, indices and pooled funds within crypto. Links to future posts will be added here:
Disclosure and Disclaimer
I’m a long term investor in crypto currencies including DeFi. I have recently become invested in $DPI and I’m an active member of the INDEXcoop which manages the $DPI fund.
This is not financial advice, all investments are risky, crypto investments are more risky than most. Do your own research. Do not invest more than you can afford to loose.
Twitter: @AnalyserOver