Applying Prospect Theory to Crypto Valuation and Portfolio Diversification
As cryptocurrencies become mainstream and gain acceptance, there is still no coherent investment framework for valuing them. Reference [1] explores the differences between equity and crypto investors and proposes an investment framework for cryptocurrencies based on the prospect theory.
The differences between equity and crypto investors are:
Stock market investors typically rely on fundamental analysis, examining financial statements, market position, and industry trends to make informed decisions. In contrast, cryptocurrency investors often prioritize technological innovation and potential rapid appreciation, leading to greater volatility and asymmetry in returns compared to equities.
Stock markets have a longer history and stricter regulations, resulting in more stable investor behavior. Meanwhile, the relatively new and less regulated cryptocurrency market experiences extreme volatility and speculative trading.
Stock investors tend to have a long-term horizon, seeking steady returns and dividends, whereas cryptocurrency investors are often more focused on short-term gains, driven by high volatility. As a result, cryptocurrency markets exhibit more irrational investor behavior.
The paper then develops an investment framework built on a utility function, where crypto investors remain risk-averse when anticipating gains. However, investor risk attitudes shift during losses; they become risk-seeking in pursuit of recovery. The authors pointed out,
The results in Fig. 2 show the superior ability of our trading strategies to earn abnormal returns. From 2014, each $1 invested in the medium-PL, low-LV portfolio accelerates to $892 at the end of 2022, which is more than four times as in the Fama-French portfolio. While each $1 invested in the low-PL, high-LV portfolio accelerates to $789 at the end of 2022, which is more than three times as in the Fama-French portfolio. The comparison with the S&P 500 index generates similar results; the values of our PL and LV based strategies are much higher than that of the S&P 500.
Similarly, Table 8 shows the average returns, standard deviations, and Sharpe ratios of the portfolios. The medium-PL, low-portfolio and low-PL, high-LV portfolio generate the larger Sharpe ratios (0.411 and 0.396) than those of the equity portfolios, token portfolio, and market benchmarks. The results demonstrate that our trading strategy based on PL and LV with token can also earn superior risk-adjusted returns.
In short, constructing a portfolio that includes both equities and cryptocurrencies using the prospect theory framework results in superior risk-adjusted returns, demonstrating that cryptocurrencies add value to an equity portfolio.
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References
[1] Zhan Wang, Xiang Gao, Jiahao Gu, Can cryptocurrencies improve portfolio diversification? Evidence from the prospect risk perspective, Research in International Business and Finance, Volume 76, April 2025, 102828
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