Why It’s Time to Diversify Your Portfolio With Bitcoin
After 10 years of Bitcoin success story, cryptocurrency and traditional investors still live in very separate worlds. One the one hand, there are the crypto enthusiasts who invest heavily in cryptocurrencies, thinking it can only go up and on the other hand, you have the traditional investors, who believe that crypto currencies are a just a fashion trend and that they are far too risky to invest in.
Maybe it is time to give up any prejudices and try to find an unbiased empirical answer for this important question:
Does it make sense for traditional investors to diversify their portfolios with Bitcoin?
The framework, which we are going to use for this analysis, is the Modern Portfolio Theory, which is one of the most widely used models in the financial industry. It makes two important assumptions:
- First, investors are generally risk averse, preferring a portfolio with a higher return for a given level of risk.
- Second, risk can be reduced through diversification.
To illustrate this theory with an example, one has to make assumptions about expected returns and risks for the different asset classes. Afterwards, a mathematical optimization derives the optimal portfolio. In order to have an unbiased analysis, we used five-year historical returns and volatilities (2014–2018). The optimal portfolio had a return of 6.2% and a volatility of 7.5%.
In the second optimization, we use the same data and add 5% Bitcoin. Intuitively one would probably assume that adding bitcoin would increase the risk of the portfolio. However, the mathematical result looks different: The return of the optimal portfolio increased from 6.2% to 7.5% with exactly the same portfolio risk.
The reason for the higher return with the same volatility lies in the low correlation of Bitcoin compared to the other asset classes, which moves the efficient frontier up. You can also say it differently: If you add Bitcoin to a traditional portfolio and use the same return, you would even reduce the risk of the overall portfolio.
The table below illustrates the correlation matrix between the different asset classes: The red fields mean a high correlation, meanwhile the green mean a low correlation (high diversification effect).
Therefore, we can conclude it makes sense to include at least some Bitcoin exposure in a traditional portfolio, as it does not increase the portfolio risk. The chart below shows historical back-testing with different Bitcoin allocations. As you can see, only a small allocation in Bitcoin can improve the overall portfolio performance significantly.
Published at Thu, 19 Dec 2019 09:39:10 +0000
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