Can cryptocurrencies improve portfolio diversification? Evidence from the prospect risk perspective

This paper develops a quantitative approach to measure the security’ risk that corresponds to investors’ prospect behaviors. From the investor’s utility maximization condition, this paper demonstrates that a prospect investor should minimize his/her exposure to prospect risk by reducing the probability of loss while maximizing loss dispersion if he/she faces loss. Importantly, in token markets, investors exhibit more behavioral bias because they expect significant positive returns while grappling with extreme tail risk, and thus prospect risk management is more useful. The empirical analysis of this paper suggests that cryptocurrencies investors with prospect risk attitudes tend to seek risk when facing a moderate loss probability level, and they would give up at most 150 bps each month to pursue higher volatility. Based on this return predictability, token investors could develop portfolio strategies by ranking token and equity assets according to their probability of loss and loss dispersion and generate superior subsequent returns; appropriate combination of equity and bitcoin could generate Sharpe ratio around 0.4 based on prospect investment strategies, which is much higher than Sharpe ratio of pure market index or pure bitcoin investment.