While traditional investment metrics often fall short when applied to cryptocurrency markets. Bitcoin’s historical volatility has averaged around 64%, compared to the S&P 500’s average volatility of 15%.
One key concept that is gaining traction is risk-adjusted returns, a metric that helps investors evaluate the performance of their investments in relation to the level of risk taken.
In this article, we will learn about risk-adjusted returns in cryptocurrency, exploring its definition, importance, and how to calculate it.
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Key Takeaways
- Risk-adjusted returns measure an investment’s performance relative to the amount of risk taken.
- Common metrics include the Sharpe Ratio, Sortino Ratio, Value at Risk (VaR), Jensen’s Alpha, and Treynor Ratio.
- Cryptocurrency investments typically require higher risk adjustments due to their volatility.
- Understanding risk-adjusted returns is crucial for building a balanced crypto portfolio.
What is a Risk-Adjusted Return?
Risk-adjusted return is a metric that evaluates an investment’s return in relation to the risk taken to achieve it. In simple terms, it looks at how much “bang for the buck” an investment provides based on its risk profile.
For example, two cryptocurrency investments might generate similar returns, but the one with lower volatility (or risk) will have a better risk-adjusted return.
Risk-adjusted returns are crucial because they provide investors with a more nuanced understanding of an asset’s performance. Instead of only looking at raw returns, investors can see how much of that return is “earned” relative to the risk involved.
“Risk-adjusted returns are particularly crucial in cryptocurrency markets, where volatility can be 5-10 times higher than traditional financial markets.” – Nic Carter, Castle Island Ventures.
Why is Risk-Adjusted Return Important in Cryptocurrency?
The cryptocurrency market is known for its high volatility, meaning prices can swing dramatically within a short time frame. This characteristic of crypto makes traditional return metrics insufficient for assessing performance accurately.
Without factoring in risk, investors may fall into the trap of favoring assets with high potential returns but also with excessive risk exposure. Risk-adjusted returns, therefore, help investors evaluate the true quality of an investment.
For instance, if a cryptocurrency delivers a 50% return in a month but experiences severe volatility, its risk-adjusted return may be less appealing than another crypto asset that yields a 20% return with minimal price swings.
Ultimately, risk-adjusted returns allow investors to make more informed decisions about where to allocate their funds in the crypto market.
“Risk-adjusted returns offer a clearer picture of an investment’s efficiency, not just focusing on how much it gains, but how much it gains in light of the risks taken.”
Key Metrics for Measuring Risk-Adjusted Returns in Cryptocurrency
Several established financial metrics are used to calculate risk-adjusted returns. Let’s explore some of the most widely used metrics that are also applicable to cryptocurrency.
Sharpe Ratio
The Sharpe Ratio is among the most popular metrics for evaluating risk-adjusted returns. It compares an investment’s return with a risk-free rate (like government bonds) and divides it by the asset’s standard deviation (a measure of volatility). The Sharpe Ratio formula is:
Sharpe Ratio = Average Return − Risk-Free RateStandard Deviation of Return
Where there’s no true risk-free rate, some investors use short-term Treasury yields or set a low arbitrary value close to zero. The higher the Sharpe Ratio, the better the risk-adjusted return.
Example: Suppose you invested in Bitcoin, which provided a 40% annual return with a standard deviation of 30%. If the risk-free rate is set to 2%, the Sharpe Ratio would be:
40 – 230 = 1.27
A Sharpe Ratio above 1 is generally considered good, indicating that the returns justify the risk taken.
“The Sharpe Ratio is a powerful tool in cryptocurrency investment, offering insight into whether high returns justify high volatility or if they merely expose the investor to unnecessary risk.”
Sortino Ratio
While similar to the Sharpe Ratio, the Sortino Ratio provides a refined approach by focusing only on downside risk, effectively ignoring any upside volatility. This makes it particularly useful in cryptocurrency, where price spikes can sometimes inflate perceived volatility.
Sortino Ratio = Average Return − Risk-Free RateDownside Deviation
The Sortino Ratio is helpful for crypto investors who want to assess how well an investment performs against negative market movements, discounting the impact of any positive volatility.
Example:
- Bitcoin’s Sortino Ratio (2023): 2.1
- S&P 500’s Sortino Ratio (2023): 1.8
This indicates that despite its volatility, Bitcoin provided better risk-adjusted returns than the S&P 500 when considering only downside risk.
Treynor Ratio
The Treynor Ratio measures return relative to systematic risk, or “market risk.” The ratio uses beta (a measure of how much an asset’s price fluctuates compared to the overall market) instead of standard deviation. The formula is:
Treynor Ratio = Average Return − Risk-Free Rateβ
The Treynor Ratio can offer insights into assets with high correlations to broader market movements, like Bitcoin and Ethereum, making it easier to compare crypto investments that are more market-sensitive.
Value at Risk (VaR)
Value at Risk (VaR) is a statistical measure that estimates the maximum potential loss of an investment over a given period at a certain confidence level. VaR doesn’t directly give a risk-adjusted return but allows investors to understand and mitigate potential losses.
For example, a VaR of 5% at a 95% confidence level means that there is a 5% chance of losing more than a specified amount within a defined period.
Jensen’s Alpha
Jensen’s Alpha measures the excess return an investment generates above the expected return based on its risk level (beta). While more commonly used in traditional finance, it’s useful for comparing returns of crypto assets that are impacted by the market. A positive alpha indicates the asset has performed better than expected for its risk profile.
Strategies for Achieving Better Risk-Adjusted Returns in Cryptocurrency
Achieving better risk-adjusted returns in cryptocurrency requires a strategic approach to managing risk while capitalizing on opportunities. Here are some proven strategies:
Diversify Across Different Cryptocurrencies
One of the most effective ways to improve risk-adjusted returns is to diversify investments. By holding a mix of crypto assets, investors can reduce the risk of a significant drawdown caused by the failure of a single coin.
Diversifying across different types of tokens (e.g., utility tokens, governance tokens, and stablecoins) can help balance returns and reduce overall portfolio volatility.
Incorporate Stablecoins
Stablecoins offer a relatively stable value, pegged to a fiat currency or asset. By including stablecoins in a portfolio, investors can mitigate losses during periods of high volatility, thus improving risk-adjusted returns. For example, Tether (USDT) or USD Coin (USDC) are common stablecoins used to hedge risk in volatile markets.
Use Dollar-Cost Averaging (DCA)
Dollar-cost averaging (DCA) is an investment technique that involves investing a fixed amount in cryptocurrency at regular intervals, regardless of price. DCA helps lower the average cost per coin and reduces the impact of market volatility on the portfolio, thereby potentially enhancing risk-adjusted returns.
Apply Stop-Loss Orders and Take-Profit Points
Using stop-loss orders can protect an investment from significant losses by selling the asset automatically if it falls below a certain price. Similarly, take-profit points can lock in gains by selling once the asset reaches a target price. Both strategies can help investors manage downside risk and secure profits, positively impacting risk-adjusted returns.
Invest in Blue-Chip Cryptocurrencies
Investing in well-established cryptocurrencies like Bitcoin and Ethereum, often regarded as “blue-chip” in the crypto world, is generally safer. These assets have higher liquidity and are often less volatile than smaller, speculative coins, resulting in better risk-adjusted returns. Additionally, these coins tend to be more resistant to market shocks, giving investors a more stable return relative to risk.
Read Also: Managing Cryptocurrency Risks: How to Protect Your Assets
Conclusion
Risk-adjusted returns are an essential concept in cryptocurrency investing, providing a framework for investors to evaluate the performance of their investments in relation to the level of risk taken.
By understanding the definition, importance, and calculation of risk-adjusted returns, investors can make more informed decisions about their portfolio allocation and risk management strategies.
While there are challenges and limitations to consider, risk-adjusted returns offer a valuable tool for cryptocurrency investors seeking to optimize their returns and minimize their risk.
FAQ
The Sharpe Ratio is the most widely used and important risk-adjusted return metric for cryptocurrency investments, as it provides a standardized measure of excess returns per unit of risk.
You should calculate risk-adjusted returns at least monthly for active trading portfolios and quarterly for long-term investment strategies to ensure your portfolio remains aligned with your risk tolerance.
No, higher risk-adjusted returns don’t always indicate better investments. The appropriate metric depends on your investment goals, risk tolerance, and market conditions.
A Sharpe Ratio above 1 is considered good for cryptocurrency investments, while a ratio above 2 is excellent, considering the market’s inherent volatility.
Risk-adjusted returns typically favor Bitcoin over altcoins due to its lower volatility and more established market position, though specific altcoins may outperform during certain market cycles.
