Modern Portfolio Theory for Cryptocurrencies- Efficient Frontier

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I love cryptocurrencies and HODL, buy, sell and have written about them for independent online newspapers (and now for my fellow Steemians 😊)

Equally, I am a student of Economics and Finance and believe in having a Balanced Portfolio of the various asset classes to suit my risk ability and risk tolerance.

This post aims to give you a quick overview of an essential financial concept, provide you with links to some excellent websites which have vital data and how this concept can be used in the world of cryptos so that you can maximise your returns while lowering your overall risk.

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Whenever I hear articles in cryptocurrency magazines urging you to build a diversified portfolio, I notice they never explain how quite to achieve this! This lack of clarity is probably a function of the imperfect availability of information (until recently) required to efficiently create what is known as Modern Portfolio Theory (MPT) or ‘Mean-Variance Framework’. However, with the collection of data over a longitudinal time period and now publicly accessible through sites such as the Yahoo Finance Cryptocurrencies Section creating an Efficient Frontier is now possible with a little elbow grease and the magic of Excel.

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Quick History of MPT and Efficient Frontier
If you have not already clicked on the links and had a review of what these concepts are about, then let me give you a quick overview of what they are and what they are not:

NOT:

1. The name Modern Portfolio Theory is misleading as it is far from being Modern. It was introduced by Harry Markowitz a Nobel Prize Winning Economist in 1952.
2. An Efficient Frontier is not a ghost town located somewhere in Nevada! 😊

ARE:

1. Have you heard the saying 'don’t put all your eggs in one basket'? Well, simplistically put that is what MPT is all about. It is all about analysing the risk-return trade-off. It is the crucial model used by Central and Investment banks, Pension funds, during the process of portfolio construction.
2. The Efficient Frontier is the cornerstone of MPT. You can think of it like this: Different cryptocurrencies will produce different returns. Say if you select three cryptos for your portfolio then the Efficient Frontier will represent the best combinations of these three cryptocurrencies. Every point on the Efficient Frontier represents the maximum expected return for a given level of risk. Below is an example of a model of an Efficient Frontier which will provide you with a better insight into this concept and its importance:

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Before you get into the couple of excellent YouTube tutorials which explain how you can construct and Efficient Frontier using Excel I have posted below, I would recommend you read this recent article by Coin Telegraph. It is a well written article on risk diversification in a crypto portfolio and will arm you with some key concepts and ideas.

After searching YouTube extensively, I found these two videos (Parts 1 and 2) which explain in a very lucid manner how to construct an Efficient Frontier (Albeit he uses stock data. For our purpose use the Yahoo Crypto link provided earlier to substitute and follow the steps). The thing is the videos are not just how to create Efficient Frontier using Excel, but he offers the logic and reasoning behind the use of the MPT and Efficient Frontier which I found most impressive and useful for someone new to the subject matter:

Part 1: How to Build Efficient Frontier in Excel

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Part 2: How to Build Efficient Frontier in Excel- CAL and Use of Sharpe Ratio

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Please do leave comments below if you need any further clarification or have any feedback.

Next time I look forward to demonstrating how another combination of top-down and then bottom-up portfolio methodologies can be adapted to cryptocurrencies to use your parameters so that you can use readily available online tools and spot crypto opportunities among the approximately 1,600 out there. I have used this technique to spot some new cryptos which I would never have otherwise looked at, and have made me significant gains in under a month.

Peace,
Shenobie