Market Cap Proportional Hedging
In my last blog post, I highlighted that Market Cap is roughly inversely proportional to risk/reward. That is, as the total value (not price) of an asset grows, that asset typically has both a smaller downside risk and a smaller upside reward. This totally ignores important factors like the value proposition and team behind a particular asset, but is useful as an approximation. We can use this approximation to guide how much of one asset we buy relative to another.
In the simplest sense, holding assets in proportion to their market cap yields an equal expected value in terms of dollars for each asset held. More concretely, if Asset A has a market cap of $1M and Asset B of $10M, you might approximate Asset A's expected move to be +/- 10%, while Asset B's might be +/- 1%. If you hold $100 Asset A and $1000 of Asset B, in the case that both assets do well, you'll earn $10 on Asset A and $10 on Asset B. This is an elementary way to normalize returns according to risk, and is basically how index funds work. The best way to invest in cryptocurrency, if you absolutely refused to give it any thought, would be (just like the stock market) to buy every asset in proportion to its market cap. But we can do a little bit better...
One step more advanced would be to explicitly pick winners (or losers) and buy every one of (except) them in proportion to their market cap. With just a little prudence, we can keep our exposure to the crypto juggernaut as highlighted in the simplest approach, while reducing (removing) our exposure to scams, schemes, and $h1+coins. Have even more opinions? Great! We can use the same guiding principle in a more specialized way to improve returns even further.
Let's say that you're confident smart contracts are going to take over the world, but you don't necessarily know which platforms will thrive and which will be beaten out. Maybe you think Ethereum will last, but don't know what will happen to Cardano, Polkadot, Solana, Tezos, Stellar, etc... Buying each of these assets in proportion to their market cap will guarantee you the exact same USD return as long as you include each platform that captures a portion of the smart contract space. Here's an example to clarify. If you followed this approach, and ETH has a $600B market cap, ADA's is $200B, and SOL's is $200B, and you have $1000 to invest, you'd buy $600 of ETH, and $200 of both ADA and SOL. Let's say that 1 year from today, the smart contract space is worth $2T. If ETH dominated and totally killed ADA and SOL, your $600 ETH investment would turn into $2,000 and your investments in both ADA and SOL would go to $0, for a total return of $1,400. Alternatively, what if each of those three capture exactly a third of the same smart contract market? In this case, your $600 ETH investment would yield $667, and your $200 investments into ADA and SOL would each yield $667, resulting in the exact same $1,400 return. By sizing positions this way, you use differences in risk to hedge each investment and guarantee you capture increases in value without having to pick the right horse.
This can be taken one step further if you're willing to put it all together and pick winners (or losers) and buy every one of (except) them in proportion to their market cap within a vertical. Then, you can determine how much of your portfolio you'd like to invest in each vertical and the rest of the calculations are easy. This is my approach.
This logic can be applied across multiple verticals. Personally, I use market cap proportional hedging in both the smart contract and oracle verticals. Checkout this spreadsheet to see some example calculations!
Hopefully this makes sense, but if not, feel free to reach out! Did I miss your favorite smart contract platform? Did I misrepresent something? Do you have a better approach? Reach out and let me know, I'd love to make it right!