Crypto Guide: The Value of Bitcoin in Building a Diversified Long-Term Portfolio

Diversifying a portfolio of securities dilutes the risk of a sharp drop in the price of an asset. Here are some tips to better manage the risks when you start trading cryptos.

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The diversification of a portfolio of stock markets (stocks, bonds, interest rate products, currency products, commodities such as gold, real estate) consists of the simultaneous combination of several investments. If you only have stocks (or bonds) of a single company in your portfolio, you focus all risk on a single signature. In the event of a severe blow to the company and a fall in the stock price, and if you don’t have a significant amount of cash at the same time, your portfolio will suffer the entire price decline.

On the other hand, if you hold stocks in two or more different companies, you bring a diversification effect into your portfolio: if one of your stocks falls, the other can offset or even catch up the negative effect of a loss in value. So if you don’t put all your eggs in one basket, you can improve the performance of your portfolio over time.

Diversify to dilute the risks in the event of a price drop

Diversify to dilute the risks in the event of a price drop

The increase in the number of different positions and also different asset classes (stocks, bonds, cash, precious metals, real estate, other real assets, etc.) increases this diversification effect. Neither is too much needed: beyond a certain number of different positions (20 to 25 securities in a stock portfolio), diversification does not make a significant contribution to reducing risk. This can even be disadvantageous: too many lines lead to more transactions and higher transaction costs without increasing the effect of diversification and risk reduction.

Stocks and bonds are the two basic asset classes of a diversified portfolio.

Stocks, formed by investing in the capital of publicly traded companies, are the most profitable investments in the long run, despite short-term volatility. Statistics from 1950, published by investment bank JP Morgan (2015), show that the one-year return on a portfolio made up entirely of stocks fluctuates between + 51% and -37%. over a period of 5 years, the maximum loss decreases to 2% and the maximum annualized profit to 28%; Over a period of 20 years there are no more losses, while the valuation of the shares is between 6% and 18%. In short, the effect of short-term volatility is eliminated with the length of the investment.

Minute definition: volatility

Volatility represents the change in the price of a financial asset and reflects the risk that it will lose value (in the event of a fall in price). Volatility is considered « high » when the price of the financial asset fluctuates significantly. Conversely, volatility is considered « low » when the price of the financial asset is relatively stable.

While their returns are generally moderate, their short- or medium-term performance exhibits little volatility compared to stocks. However, during times when the rate of inflation is higher than the yield on bonds, the investment won’t pay off in constant money. This is called negative real interest rates. And since long-term inflationary periods are inevitable, investing in bonds, regardless of how they occur, is ultimately riskier than investing in stocks. While government bonds or large state-owned corporations are a guarantee of security, it should be noted that private corporations’ debt obligations are riskier. Indeed, when the latter files for bankruptcy, the creditor often only withdraws part of their investment. However, it should be qualified: certain bonds from large, world-famous companies are considered safer than bonds from certain countries, especially emerging markets.

The main disadvantage of diversification is that it may not work in certain time periods, meaning that each asset class is moving in the same direction at the same time. We therefore speak of a positive correlation in this case. A « correlation of 1 » means a perfect correlation, a « correlation of -1 » means a perfectly inverse correlation (one asset falls while the other rises), and a « correlation of 0 » means a full decorrelation. An example is the episode of the sovereign debt crisis in Europe in 2010-2012, when the sovereign bond market fell along with the decline in stocks.

To respond to this problem, a portfolio that has traditionally been made up of stocks and bonds is often added the inclusion of asset classes and so-called « alternative » investments that are supposed to be able to establish an effective correlation. We can therefore cite real assets like real estate (but this can sometimes clearly correlate with stocks and bonds), forest stocks, « private equity » (stocks or funds of unlisted companies) or other sophisticated investment strategy funds for decorrelation (« hedge funds » or alternative funds) .

In the past, gold and precious metals have achieved an effective decorrelation effect. Gold is the most traditional alternative investment: given its reputation as a safe haven, it tends to rise when other asset classes fall. It is also a bulwark against inflation. However, it does not offer any return (no dividends or coupons) and is still subject to the laws of supply and demand, which can sometimes lead to sudden price fluctuations.

More recently, with cryptocurrencies and the development of all digital assets, a new opportunity for diversification and decorrelation has emerged. Obviously, at the top of the list is Bitcoin as a new asset to be made available to the investor or asset manager.

Bitcoin’s contribution to portfolio diversification

Bitcoin's contribution to portfolio diversification

There is a lot of heated debates about whether Bitcoin is really a currency. Most economists oppose the idea because Bitcoin is not issued by a state or managed by a central bank (the decentralization of its operations is even one of its characteristics). If we examine Bitcoin from the perspective of the 3 classic functions of money (unit of account, means of payment and store of value):

Bitcoin has proven itself since it was founded over 10 years ago: As a payment method, more than 30 million users transfer and exchange this digital currency worldwide every day. Despite the volatility of the price, its capitalization is more than $ 350 billion (Bitcoin remains the leading cryptocurrency as of November 24, 2020) and, above all, its liquidity gives it a status and legitimacy as a reserve asset.

“The correlation of Bitcoin with other financial assets averaged 0.11 from January 2015 to September 2020, which indicates that there is almost no correlation between the price of Bitcoin and that of other assets”: This observation appears in a recent report by the Americans Report produced by the asset management company Fidelity. In fact, Bitcoin has little or no correlation with traditional financial markets. However, this is an average over 5 years (from 2015 to 2020), which must therefore be put into perspective. So be aware that the correlation with gold has increased significantly recently and Bitcoin tends to value Bitcoin more than gold. Regardless, in the long run, Fidelity finds that Bitcoin can be viewed as a portfolio diversification tool that can move against traditional markets.

The following table clearly shows the good decorrelation of Bitcoin compared to all important asset classes in the period under review. On the other hand, the major classes of financial and real estate wealth (REIT) are fairly correlated, even very clearly correlated with each other.

Like Bitcoin, only gold has extremely low correlation with other major asset classes.

To highlight the beneficial effect of Bitcoin in terms of diversification, the Fidelity study measured the effects of low diversification of Bitcoin over 5 years on a typical investment portfolio (60% of stocks and 40% government bonds). Over a period of 5 years, the study compares 4 different wallets, each with between 0% and 3% Bitcoin. The following graph shows the results of the 4 portfolios in 2020 (YTD) after 1, 2, 3, 4 and 5 years and in the period 2015-2020:

The end result is pretty clear: adding bitcoin systematically increases the performance of wallets. In fact, Bitcoin’s high volatility (averaging more than 50% compared to around 20% for large-cap stocks) is less of a blunder given Bitcoin’s performance in recent years.

In addition, the recent increase in Bitcoin’s correlation with gold seems to suggest that some consensus is emerging. Isn’t Bitcoin referred to as « Gold 2.0 » and is it a rare and deflationary asset? The two-month smoothed correlation between Bitcoin and gold hit an all-time high in September – certainly due to inflation fears and the fact that real interest rates are heavily negative, favoring gold and bitcoin, which are both assets that don’t generate coupons or dividends.

Minute definition: real interest rate

The real interest rate is the difference between the nominal interest rate and the inflation rate observed for a reference period. For example, if the nominal interest rate on an investment is 5% and the inflation rate is 3% over the same period, the real interest rate is 2%. The real interest rate is therefore the real rate of return for the investor and the real cost for the borrower.

The year 2020 was unique and showed a general correlation between asset classes, stocks, bonds … but also with gold and Bitcoin, especially during the stressful phase of the markets in March at the beginning of the health crisis. Everyone will remember Bitcoin’s 50% slump in March at the same time as Wall Street.

As always with crypto, only the future will tell whether the bitcoin / gold correlation will hold and whether the correlation between gold / bitcoin / traditional asset class will persist in future phases of market stress. Because as with gold, which occasionally suffers from these flux phenomena, the queen of cryptocurrencies has already got us used to short periods of high correlations with other assets … correlations that have dissolved over time.

Graphic sources: Fidelity Digital Assets

Crypto Guide: The Value of Bitcoin in Building a Diversified Long-Term Portfolio
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