By Cavin Ojijo
Cryptocurrencies Can Be Used to Outperform Inflation
Kenya is on a path to the digitization of critical sectors of the economy, including financial and asset management systems. With rapid technological development, digital currencies are already a part of the country’s financial markets. Although the technology is relatively new, evidence suggests that an increased adoption of digital contracts has already allowed cryptocurrency to be a critical player in the country’s financial space.
While cryptocurrency carries value and facilitates digital payment, the current legal standing of cryptocurrency does not enable effective control and stability related to relatively unregulated flow and abrupt changes in value. However, the path to digital currency predicts a world economy in which cryptocurrency will be a major player, with trillions held in the crypto asset portfolio. Kenyan investors have responded to this drive by embracing portfolio diversion, which is making inroads into cryptocurrency.
Diversification is based on the premise that when a portfolio comprises different asset classes, the investment, on average, will generate more returns due to reduced exposure to risk than an investment built on assets of the same class. A good diversification consists of a portfolio comprising different types of securities and stocks with varying risk exposure. This kind of diversification aims to weed out unsystematic risk events by allowing the portfolio to balance the losses from a non-performing asset class with the gains from a performing asset class. The realization of this objective necessitates that assets included in such a portfolio mix should not belong to the same class and should not have a perfect correlation. Built on the argument that cross-asset diversification has more benefits than assets of the same class, the imperfect correlation of cryptocurrency to other traditional assets suggests that it can be used as a diversifier.
There are concerns that cryptocurrency’s anonymous and unregulated nature poses significant regulatory threats to the standard national currency. The threat spans from abstract economic risk to functional losses. Cryptocurrency is both a target and a conduit through which value can be transferred. Cryptocurrency offers a way for investors to hold a diversified portfolio, including cryptocurrencies, which diversify their exposure to multiple risk indices, thus optimizing their returns while being exposed to minimal risks.
Over the long term, cryptocurrencies tend to be uncorrelated, negatively correlated, or have little correlation to traditional and alternative assets; thus, they can be used to outperform inflation, which makes them a reliable hedge against inflation. Investment has two trends: Bulls and Bears. Bulls represent a market uptrend, and bears represent a bear downtrend. Value investing permits buying or holding cryptocurrency on negative(bear) trends and selling on positive (bull) trends; thus, profit optimization.
Cryptocurrency as an investment is appealing to individuals due to its beneficial potential. Many investors are attracted to portfolio diversification, which combines traditional and alternative assets that ultimately bring more returns and have fewer risks. Today, several industries are embracing cryptos as forms of value, and various economic sectors such as telecommunication, energy, financial, healthcare, and information technology already operate in blockchain cyberspace supported by crypto payments. The potential benefits of digital currencies have, over time, attracted people to invest. Traditional stock can diversify a portfolio; however, this approach has two main shortcomings built on close correlations. One is that constructing a portfolio without considering the potential association risks can harm the portfolio. Financial investment requires investors to manage and control the dangers they expose themselves to while reaching higher returns. Accordingly, investments with high returns also entail high risks. Thus, a trade-off exists between the return and risk in the decision-making process regarding an investment. Financial theories define investment risk in ways that can be measured by relating the measurable threat to the level of return expected in each asset. While various portfolio management approaches exist, a solution could be to mix the traditional market pattern that affects traditional stock with the modern and more robust dynamics that affect the value of cryptocurrencies.
Portfolio risk is the aggregated risk of all investments; when the return of traded stocks is not closely correlated, the stock market offers investors a broad range of investment opportunities. According to modern portfolio theory, the overall risk decreases as the number of securities increases. Two options are available to investors: holding assets with different risk combinations or reducing the investment risk by improving their security portfolio. The latter approach is known as portfolio diversification. The theoretical foundation of portfolio diversification was introduced by the work of Markowitz (1959) and later developed by Sharpe (1964); by including assets with different rates of volatility and directions within their portfolio, investors can reduce the risk of significant losses that would result if only one response is included. In Markowitz’s initial assumption, risk aversion is principally concerned with the mean rates of return and the risk involved as measured by the standard deviation or variance of the mean rate of return.
Research on the 1987 October crash offers more convincing proof of diversification’s influence on risk management. Shiller interviewed financial specialists after the accident and discovered that very few thought modern portfolio theory still holds. The insiders attributed the reduced risk to the observation that portfolios that move in different directions or at different speeds relative to market changes could eliminate, offset, or reduce losses. The cream of the proof is that stocks react not exclusively to changes but also to other factors that influence prices. Studies on mean-reversion aim to find evidence of the influence of diversification on stock and try to map stock relative to risk.
On the other hand, if changes in the market have a varied effect on different types of stock, waging against it would mean using diversifiable risk, which cushions the impacts of various kinds of stock. This shows that diversification can only have an articulated effect when the securities involved move in different directions or speeds relative to stock changes that affect stock prices. This conclusion can be proven in an ideal capital market without any trading limits or costs of becoming conscious of the price disparity of securities. In an actual market situation, however, diversification is expensive, and arbitrageur would commit capital to securities whose returns will be worth the risk of bearing the expenses. Consequently, investor’ decision to diversify the reach of their stock would cushion them from the failure of one stock. This strategy will influence the risk associated with these stocks because investors’ resources and perseverance are limited. If a stock is underpriced or overpriced, it would only be cushioned by a stock that responds differently to these forces. Investors may use elective options or diversify their stock portfolio through stock investment to stand against expected market risks.
In portfolio theory, Harry Markowitz 1952 argued that investors should solely base their investments on each portfolio item’s expected returns and standard deviation. In these cases, expected returns are the benefits of holding a portfolio over time, and the standard deviation is the measure of risk associated with the portfolio for the same period. Since an infinite number of portfolios can be built from a set of securities, the task is determining the most suitable model. The Efficient Set Theorem argues that investors will choose the optimal portfolio set that:
1. Maximizes benefits for a certain degree of accommodatable risk
2. Is the minimum risk attainable?
These two conditions are known as the efficient set. The process first involves identifying which types of assets best fit the investor’s needs; from this list, the investor is guided by plotting the indifference curve developed from the portfolio and choosing a portfolio with the most returns at the lowest risks.
Furthermore, employed diversification means an investor bears a little nonsensical risk, which is expensive, especially for undiversified types of investments. Lastly, as emphasized by Fischer Black, diversification is responsive to underpriced security that restricts their readiness to trade during the downturns by allowing some types of stock to have an uptrend. It follows that diversified stock investment used in trading against any mispriced security is limited. As such, the investment is relatively shielded from excessive losses when the market faces a downturn. Standard models used in financial markets, in which investors are disinclined to take unnecessary risks, suggest that portfolio diversification influences risks.
The argument that the diversification degree of a portfolio influences risk is substantial.However, one also anticipates that firm-explicit opinion should influence individual securities. This evidence and theories lead to the conclusion that the possibility of diversification of stock securities risks serves the investor’s interest if it is adequately planned.
Cavin Ojijo is an Audit Assistant Manager at CliftonLarsonAllen (CLA)