Hello Bubble Riders!
I’m going to do something a bit different in this one, since this post will be a more detailed analysis of a post I wrote for Quora this week (original post here). The idea just kept on turning out even better with more data. So, I had to do a follow on.
In a line: this is the closest to a “passive income” growth scheme I’ve come across in cryptos. It outperforms the stock market. It outperforms the crypto benchmark (BTC). It outperforms merely yield farming.
It’s also quite simple to implement.
We’ll discuss ways to boost returns at the end (something our subscription will help with obviously), but let’s start with the basics. The idea is a development of the stock market’s 60 / 40 portfolio … which has been crushed in the recent environment.
1. The 60 / 40 Stock Portfolio
The conventional wisdom for portfolio management says that you should divide up your investments 60% into stocks and 40% into bonds.
For the stock market, you could buy the $SPY (S&P 500 index) or the $QQQ (Nasdaq 100). For bonds, you’d buy something like the $TLT (20-year US treasuries) or the IEF (7 – 10 year treasuries). The rationale for this approach is the following:
- The 60% stock exposure was supposed to give you up-side exposure, and
- The 40% bond exposure was supposed to protect you in the down times.
Here’s a link to the Morgan Stanley explanation.
Here is how that portfolio has performed since 1999–using the following allocation: 30% SPY, 30% QQQ, 40% TLT.
It beats the market. Here’s a run-down of the year over year returns.
You’ll notice four main things:
- It declines every year that the stock market does.
- It underperforms the stock market most years (beating it only 11 out of 23 years).
- It generates alpha (outperformance) by losing less during most down cycles.
- It has performed terribly this year.
That last point is important, since the 60 / 40 only generates alpha during declines and it didn’t do that this year.
That portfolio has performed terribly this year. The reasons are double.
- Problem 1 – Bonds only provide downside protection in declining GDP (growth), not an inflationary environment.
- Problem 2 – 40% downside protection isn’t enough, since stocks represent 95% of your risk!
2. How Do You Fix That?
The first problem concerns bad environments. There are two of these: declining GDP and high inflation.
What does well when the economy (GDP) craters? Bonds. Here’s the TLT’s performance in the 2008 crash.
What does well when inflation soars? Commodities such as oil or gold. Here’s how crude has performed for this year.
So, to fix the first problem, your portfolio is going to need stocks, bonds, and some commodities.
To fix the second problem, you need to reduce your stock exposure to about 30% — because stocks make up the majority of your portfolio’s volatility.
Ray Dalio, the founder of Bridgewater, which is the world’s largest hedge fund, combined these principles for ordinary folks and gave you the following distribution.
- Gold – 7.5%
- Commodities 7.5%
- Stocks – 30%
- Intermediate Bonds (IEF) – 15%
- Long Term Bonds (TLT) 40%
I plugged that into a back test for you. Here’s what you get: 7.46% compound annual growth rate.
It beats the market, but that leaves a lot to be desired–that amount isn’t even beating inflation at present.
That’s why allocating a small portion of your portfolio to cryptos looks intelligent, even if you’re not super into cryptos. Let’s see if we can’t adapt the above insights for a crypto version of a 60 / 40 that gives us better returns.
3. The Crypto 90 / 10
In the crypto world, you don’t have bonds. But you do have yield farming. There are a few varieties of this, and some are not really that safe (just as some bonds are also incredibly risky).
I’ve written about yield farming rather extensively elsewhere, so let’s just assume that you know how to pick safe yield farming positions and can get 13% APY from your activities.
Next, just like the 60 / 40 portfolio, let’s try not to be smart. Instead, let’s just pick the benchmark (BTC) and use that for our analysis. Notably, if you want better returns, you could probably substitute ETH.
Finally, let’s take a few insights from Ray Dalio. First up, since yield farming returns positively regardless of market direction, you don’t need to worry about underperforming in a high inflation environment. You just need yield farming, not yield farming + something else (as you need bonds + commodities in traditional finance).
Second, we need to recognize that cryptos are far more volatile than stocks. So, we’ll have to reduce their position to even less than 30%. Back testing shows we need to reduce it to just 10% of the portfolio.
If you do that–90% in yield farming at 13% APY + 10% in BTC–this is what you would have as a result for 2022. The blue line is our 90 / 10 portfolio, while the red line is the result of just HODL-ing BTC.
Not only is the portfolio positive by about 2%, it also beats the performance of the QQQ (-31% this year), the SPY (-20.7%) and the 60 / 40 portfolio (-29.9%).
Of course, this distribution isn’t going to return nearly as well as BTC in a bull run. Supposing that we had yield farming available in 2018 (I synthetically represented the results for this back test), then this is what you would get.
That’s a 73.6% return for the 90 / 10 vs. 239% for just HODL-ing BTC.
It would make sense, then, if you could have an algorithm that identified roughly when to trade out of a bull run or a bear market. That way you could get the best of all worlds … which would be exactly what our AOTB Dynamic portfolio does.
But I digress.
The really interesting picture emerges when you combine the previous two charts.
Yes, the 90 / 10 is outperforming holding onto BTC since 2018. We’ve got a 68% return vs. 51%.
It’s also a lot less volatile = better risk adjusted returns by miles.
This portfolio is rather simple. Just plunking 90% of your crypto investment yield farming and HODL-ing the benchmark actually beats the benchmark in overall returns and in risk adjusted returns.
It also beats the 60 / 40 in stocks (which has given about 27.8% since 2018 v. 68%). And the returns from this portfolio are so consistent, you could practically build a business on it.
Now, the ideal way to improve returns is to use something like our AOTB Dynamic Portfolio. It does take on a little more volatility, but it catches those upsides.
You could also modify this approach by substituting ETH for BTC in this process. That will make the portfolio more volatile, but it’ll catch a lot more of the up-side.
If you want to rotate between the two, you could use your crypto-maxi strategy to do that–and that does significantly bump returns (about 3x for your crypto portion through the last crypto winter).
Or you could use a version of crash cost averaging. This smarter version of dollar cost averaging is massively outperforming this year (it’s up about 18% as the rest of the market is obviously in the dumps).
Finally, if you want to keep up to date on yield farming information (the 90% of this fund), our weekly newsletter (for $15 / month) will identify some of the best spots. That’s the most important part of this strategy, but it shouldn’t take more than 1 time a week monitoring.
This week I wrote a number of pieces that are related to this post, so you might want to have a look if you’ve missed them.
That’s it for this week. Remember to join us on Discord if you haven’t already.
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