Top-Down Approach to Portfolio Allocation

As cryptocurrencies continue to grow in popularity, more and more people are looking to invest in them. But how should you allocate your crypto portfolio, depending on your investment goals?

Buying the right tokens is essential to have a good return. However, building a solid portfolio requires much more than buying a bunch of tokens you like.

Portfolio Allocation

In traditional finance, portfolio allocation is the process of dividing an investment portfolio among different assets. The goal is to balance risk and rewards so that the portfolio can generate the highest possible return for a given level of risk.

Many models have been developed over the decades: Markowitz portfolio theory, the Black-Litterman model, and Risk-parity, to name a few.

However, such models cannot apply in crypto due to the;

• High volatility of assets

• A high correlation between assets.

However, some rules and heuristics can be used to construct a properly diversified portfolio of crypto assets.

Bottom-Up Versus Top-Down Approach

There are two main approaches to portfolio allocation.

The top-down approach emphasizes the selection of individual assets and aims to identify tokens that can generate higher returns than the market average.

Assets are researched individually and selected according to their specific characteristics. Usually, the allocation of a single investment is subjective, based on the investors' conviction in the asset's future performance.

The term bottom-up refers to the fact that the portfolio is built by picking single assets. This approach can lead to a poorly diversified and concentrated portfolio. You might bet big on a single token and might be wrong. Additionally, the investor decides allocation to different asset classes and sectors in the top-down approach. Then, within each of those, determines the allocation of subsectors, down to the allocation of the single asset.

Example: A classical TradFi portfolio allocates stocks, bonds, gold, commodities, and cash. It could be 30% stocks, 20% bonds, 20% gold, 10% commodities, 20%cash. A more conservative investor could prefer a higher allocation to cash against stocks, etc.

Among stocks, you could further subdivide in sectors or according to geography (US stocks, European stocks…). Bonds can be subdivided according to duration, rating, and sovereign/corporate. For each subsector, the investor also decides on an allocation.

How is the allocation of the single asset calculated?

You want to buy JPM shares. The bank is solid, has good revenue prospects, and you decide to allocate 10% of US financial stocks to JPM. The final allocation is 30%*50%*20%*20%=0.6%.

This way, the portfolio will be diversified according to different metrics by design. Your insights and research are put in a framework that gives more value and structure to them.

Top-Down Approach for Crypto

There are some similarities between crypto assets and traditional assets. They may appear as follows;

• Bitcoin= Gold

• Stablecoins= Cash

• Blockchain tokens (Layer 1 and 2)= Commodities

• DApps tokens= Equity

Given this equivalence, the first allocation you would make is to the above categories. A more conservative portfolio will have a higher percentage of stables and Bitcoin, while a more aggressive portfolio will allocate more to blockchain and Dapps tokens.

Final Thought

Now that you have your allocation, when will you rebalance it? You have decided on the weights for the tokens, so you should keep those weights more or less constant. It would help if you rebalanced whenever your actual weights differ substantially from your target weights.

Target allocations may change from time to time. For example, you might become bullish on a particular chain due to some significant update. In this case, all the weights will change, and a rebalance will probably be triggered. Thus, using a top-down approach will give structure to your portfolio. It is a complementary tool to your research and analysis, which will help you to diversify allocations according to multiple risk factors.