Why it is wise to add bitcoin to an investment portfolio

“NSIVERSIFICATION is both Observed and wise. Rules of action that do not imply diversification dominance must be rejected, both as a hypothesis and as a saying, “says Harry Markowitz, a very talented young economist. increase. Journal of Finance This treatise, which helped him win the Nobel Prize in 1990, laid the foundation for “modern portfolio theory,” a mathematical framework for choosing the optimal spread of assets.

Theory assumes that rational investors should maximize his or her returns compared to the risks they are taking (return volatility). Not surprisingly, profitable and reliable assets should be featured in a wise portfolio. However, Markovitz’s genius has shown that variance can reduce volatility without sacrificing returns. Diversification is a financial version of the idiom that “the whole is greater than the sum of its parts.”

Investors seeking high returns without volatility may not be attracted to cryptocurrencies such as Bitcoin, given that they often plunge and rise in value. (In fact, while Buttonwood was writing this column, it was exactly what Bitcoin did, dropping 15% and then bouncing back.) But the insight Markowitz revealed is that investors. What was important to us was that it was not necessarily the risk of the asset itself. As a contribution to the volatility of the entire portfolio, it is primarily a matter of correlation between all assets in the portfolio. Investors with two weakly or uncorrelated assets can rest assured that if the value of one plunges, the other asset may hold the rationale.

Consider the combination of assets that a wise investor may hold. Geographically diverse stock indexes. Bonds; listed real estate funds; and perhaps precious metals like gold. The assets that generate the most juicy returns (stocks and real estate) also tend to move in the same direction at the same time. Equities and bonds have a weak correlation (about 0.2-0.3 over the last decade) and may be diversified, but bonds also tend to lag behind in terms of returns. Investors can reduce volatility by adding bonds, but returns also tend to be lower.

This is where Bitcoin has the upper hand. Cryptocurrencies can be very volatile, but during their short life it also had a high average return. The important thing is that they tend to move independently of other assets. Since 2018, the correlation between Bitcoin and stocks in all regions has been 0.2-0.3. Over a longer period, it becomes even weaker. Correlation with real estate and bonds is similarly weak. This makes it an excellent potential source of diversification.

This may explain its appeal to some large investors. Hedge fund manager Paul Tudor Jones says he aims to hold about 5% of his portfolio in Bitcoin. This allocation looks wise as part of a highly diversified portfolio. Over the last four periods of the last decade, randomly selected by Buttonwood for testing, the optimal portfolio included a 1-5% Bitcoin allocation. This isn’t just because cryptocurrencies have skyrocketed. Even if you cherry-pick a few particularly volatile years with Bitcoin, for example from January 2018 to December 2019 (when it plunged), a portfolio allocated to Bitcoin at 1% is still a better risk. Showed-a reward feature than one without it.

Of course, not all calculations about which asset to choose are easy. Many investors want to not only make good investments, but also good things. Bitcoin is not eco-friendly. In addition, to select a portfolio, investors need to collect relevant information about the behavior of their securities. Expected return and future volatility are usually measured by observing how an asset has worked in the past. However, there are some obvious flaws in this method. Past performance does not necessarily indicate future returns. And the history of cryptocurrencies is short.

Markovitz explained how investors can optimize their asset choices, but writes that “we are not considering the first step, the formation of relevant beliefs.” Revenues from investing in stocks are part of a company’s profits. Risk-free rate and credit risk from bonds. Other than speculation, it is not clear what drives Bitcoin returns. It is reasonable to think that you may not be profitable in the future. And many investors have a fierce philosophical belief about Bitcoin-either salvation or punishment. Neither side is likely to own 1% of the assets.

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This article was published in the print version of the Treasury and Economy section under the heading “Just add crypto”.

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