Crypto has a low correlation with stocks. What does that mean?
Stocks, bonds, real estate, commodities. Bitcoin.
Bitcoin? Is cryptocurrency an asset class deserving of a place in every endowment and retirement portfolio?
There is now being built on Wall Street a modern portfolio theory of bitcoins: elaborate demonstrations that a dose of virtual currency will enhance the return or reduce the risk of a portfolio. Be prepared to be bombarded with Sharpe ratios, correlations and optimum allocations.
It could be that all of this fancy arithmetic is proof of virtual currency’s legitimacy. Or it could be nothing but the sign of a top.
Here, I will present the cases for and against an allocation to bitcoin in an investment account, while endeavoring to take a neutral position on where the price of this asset is headed. It’s a 50-50 proposition. Virtual currencies might prove their worth competing against debased fiat currencies, sending bitcoin to $400,000. Or they might be destined to go the way of the South Sea Bubble.
Bitcoin has seen three phases in its 12-year life. The first was Silk Road: a payment mechanism, a Western Union for drug deals. The second phase was speculation. Speculators bought at $570 and sold at $5,700 to another bunch of speculators, who bought at $5,700 and maybe would have sold at $57,000 if the opportunity hadn’t been so fleeting.
Now we are in the third phase: institutional. August entities like Fidelity, BlackRock, J.P. Morgan and MassMutual are joining in as custodians, portfolio managers or cheerleaders. Indeed, maybe we should include Coinbase on our list of venerable institutions. The ten-year-old trading venue for cryptocurrencies presides over $90 billion in assets and is about to go public at a valuation rivaling Charles Schwab’s.
The institutional fans come equipped with statistics. At heart, modern portfolio theory is just the old eggs-in-one-basket adage dressed up in mathematical terms. The reason to diversify, MPT says, is that you can get the same return as on a less diversified portfolio but with less volatility, or, equivalently, keep the volatility constant while getting magnified returns via some leverage.
One of the statistics trotted out in this exercise is a ratio popularized by economist William Sharpe. It compares returns to volatility. The higher your Sharpe ratio, the more you’re earning at any given level of risk. What do you know? Cryptocurrency has a fabulous Sharpe.
Bitcoin is fearsomely volatile, but it has more than made up for that with appreciation. The Coin Metrics Bletchley Index clocks bitcoin’s Sharpe ratio over the past five years at 1.6. That compares (per Morningstar) with 1.1 for the Vanguard Balanced Index Fund, which is about as diversified as you can get using stocks and bonds.
If you could invest with hindsight, you’d go back in time, put 100% of your money in crypto and hold tight to the roller coaster. Over five years you would have multiplied your cash 105-fold (see chart).
No institution, at least not the ones cited above, advocates a 100% allocation to crypto for a retirement portfolio. So now we get into the next round of MPT statistics, correlation coefficients. These are used to make the case for putting a little bitcoin in a portfolio that consists largely of a sedate balanced fund.
The correlation between two series of historical returns measures the degree to which the two assets track one another. A correlation of 1.0 means they march in lockstep. A 0.0 reading means they aren’t connected. The whole point of diversification is to put together a mix of different assets that have low (or negative) correlations with one another. The case for throwing a few real estate investment trust shares into your asset mix is based on correlations:…