Fitting Bitcoin Into An Investment Portfolio

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Bitcoin and other cryptocurrencies are a curious asset class. Bitcoin attracts scepticism because it has no intrinsic value, no cash flows, and, according to some, speculative fever drives its price. Before starting my blog (and even before doing research for this post), I was also unsure why people invested in bitcoin. But as I've discovered during my findings for my previous post, the value of Bitcoin comes from its monetary policy, its functionality and its more precisely a non-discretionary one. Besides, as it turns out, you can generate a yield on bitcoin and other cryptocurrencies. I will probably come back to this topic in future discussions, but the most keen ones could check out this article from Interaxis about ways to earn income from cryptocurrencies.

So, why would someone want to invest in Bitcoin? And how can they do so?

Before I go any further, I will make a quick disclaimer. This post is not investment advice as I myself would not take any from someone, especially from anyone who only has a few months of experience on the topic.But I enjoyed reading about how Bitcoin can fit into an investment portfolio and so feel obliged. I am merely presenting my findings. 

Bitcoin and a Portfolio

If you spend a lot of time on Twitter and Reddit, I'm sure you can write a long list of arguments for investing in bitcoin. I, however, will focus on two main ones, in my humble opinion - portfolio diversification and inflation hedging. 

Although it may not sound intuitive, as bitcoin is one of the most volatile assets, allocating a small percentage of a portfolio to bitcoin can actually help with its diversification. Despite having high volatility, bitcoin has a low correlation with other assets (when two assets have low correlation, they will move in the same direction but not by the same amount). Let us explore what the risk-return profiles of two portfolios, one more aggressive (100% equity) and one conservative (60%/40%), look like after adding bitcoin.

The overall volatility of the aggressive portfolio will indeed go up as we increase the allocation to bitcoin. 

Looking at Morningstar's data over the three years ending December 2020, 10% invested in bitcoin increases the volatility of the aggressive portfolio by 3.44% while being compensated by a 7.21% additional return. Hence, in the short term, the additional returns generated from bitcoin allocation will be enough to offset the rising volatility.

Over ten years, however, the results are less appealing. The volatility of a portfolio rises significantly even with only 1% of the funds allocated to bitcoin.

What if we first add bonds to the aggressive portfolio and then add bitcoin?

Sacrificing 4% to bitcoin in a 60/40 portfolio by reducing equity and bond sides by the same amount, and then rebalancing it every quarter, will improve the overall return from 10.5% to 21.6%, according to one of the latest CoinShare reports. Besides, the Sharpe ratio (a measure of risk-adjusted returns) increases from 0.98 to 1.99, implying a positive impact on a portfolio. In the meantime, A 4% bitcoin allocation increases the volatility of the 60/40 portfolio by 1.3%.  

On top of simply adding bitcoin to the 60/40 portfolio, the report's authors also compared bitcoin with other possible diversifiers like gold, real estate, commodities and private equity. They found that bitcoin provided a stronger diversifying effect than the other assets over the same period due to the asymmetric return profile. The return on the 60/40 portfolio with 4% bitcoin weight has a return of nearly double that for other portfolios, while the max drawdown (a max loss) does not differ much. 

In case I'm not making a strong enough case for bitcoin's diversification properties, the findings by Bouri, Molnár, et al. 2016 showed that bitcoin is indeed an effective diversifier for most asset classes, except for Japanese and Asia Pacific equity. In their research, Bouri, Molnár, et al. 2016 looked at bitcoin's return against the returns of global equities (using local equity indices), the bond index, the US dollar, the commodity index, gold and oil on a daily and weekly basis.

If we go back to the topic of correlations, bitcoin is negatively correlated to the USD, according to Morningstar's data. And this is not surprising. Bitcoin's supply growth is fixed and capped at 21 million coins, while the US Federal Research has been printing new money for over a decade. Since March of 2020, the Fed's balance sheet has increased from $4.3 trillion to $8.3 trillion by the end of August 2021. If we glance at what has happened with bitcoin’s price over this period, we can see that it rose by about 760%, according to CoinDesk data.

It brings me to the second reason for including bitcoin in an investment portfolio - hedging opportunities against inflation. In other words, bitcoin allows for accumulation of value over time, while all other assets denominated in fiat currency lose their values (an implied definition of inflation) as long as the supply of these currencies continues to grow. 

The research by CoinShare also showed that the positive relationship between inflation and bitcoin is getting stronger, suggesting that the inclusion of bitcoin in a portfolio is a prudent measure to protect against out-of-control inflation.

All in all, arguments can certainly be made that a small allocation to bitcoin could make a well-diversified portfolio more robust, while not blowing up its volatility. But since I always try to present both sides of an argument, I will finish this section with a few closing thoughts. 

Bitcoin’s low correlation with other assets should be the starting point of one’s analysis of bitcoin’s investment properties. One also needs to understand what bitcoin can offer and what makes it unique. As Chen and Popatlal from Schroders pointed out a low correlation between assets does not yet make a diversified portfolio. An asset needs to be different from other assets in a portfolio in terms of drivers of returns that can be easily identified. This means that despite having a low correlation, two assets could be negatively impacted by a certain economic or political event. Beside, as bitcoin gains attention, the evidence shows that its correlation with other assets starts to creep up, hurting the argument of a good portfolio diversifier.

Buying Bitcoin

I have to be honest: when I was planning this post, I did not expect the investment part to take up so much space. I will try to make this section more brief. 

Investing in cryptocurrencies differs from traditional assets. There is a technological risk that one needs to consider - understanding blockchain technology and storing the coins. I am not going to dwell on the former one as you can check one of my earliest articles about the underlying concepts of bitcoin.

You can buy and store bitcoin or any other cryptocurrency through crypto exchanges. But as the cryptocurrency industry continues to grow, it is starting to attract more attention from the regulatory bodies. Take the most recent regulatory saga between the UK Financial Conduct Authority and Binance’s UK affiliate.

So one might consider starting with checking which exchanges are authorised to offer their products in your country. UK investors can find the FCA guidance on cryptocurrencies here and use the FCA Financial Services Register to check the exchanges. Trading, withdrawal and deposit fees are also very important, as they can eat into your returns. Finally, there is not a centralised entity that ensures exchanges in most countries. This means your coins could be permanently lost if something happens to the exchange, for example, in case of a hack. And apparently, exchange hacks are not uncommon. I would recommend this article on the subject of exchanges' hacks. 

After one acquires bitcoins or any other coins, one needs to decide how to store them. There is a need for a digital wallet - a piece of software or hardware. 

There are different types of software wallets. Many exchanges and trading apps offer wallet hosting (also called hosted wallets) to make bitcoin ownership user-friendly. This is similar to stockbrokers, who hold shares for you.

Some companies provide software for non-custodian, self-host wallets. These wallets put users in complete control of their coins. Users don't rely on a custodian - third party - to keep their crypto coin. And there are also hardware wallets, which look like USB drives but have specific software for storing crypto. You can check this guide for a more detailed explanation on the wallets.

Hardware wallets are deemed to be the safest way to store the coins because as long as they are stored safely, only the owner has access to the coins in the wallet. Non-custodian, self-hosted wallets are somewhere closeby, but not as secure as the former ones as users have to rely on a third party for providing the software. 

So researching and understanding the different digital wallets should also take some of your time. Bitcoin.org has a help tool for choosing a bitcoin wallet.

Lastly, it is also worth checking that exchanges allow transferring coins to an external digital wallet.

Final Thoughts

Investing in bitcoin is harder than in any other asset. It is not easy to value it. One needs to consider how to fit bitcoin in a portfolio and how to store it properly.

Therefore, the best advice on bitcoin investing that I found is to find an individual reason to hold bitcoin, incorporate it into your investment plan and stick with your investment thesis ignoring the outside noise. 

Disclaimer: This blog post is not intended as financial advice. It is provided for information and entertainment purposes only. Do your own research.