“DIVERSIFICATION IS BOTH observed and sensitive; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim, ”wrote Harry Markowitz, a prodigiously gifted young economist, in the Finance Review in 1952. The article, which helped him win the Nobel Prize in 1990, laid the groundwork for “modern portfolio theory,” a mathematical framework for choosing an optimal asset allocation.
The theory postulates that a rational investor should maximize his returns relative to the risk (the volatility of returns) he takes. It follows, of course, that assets offering high and reliable returns should feature prominently in a wise portfolio. But Markowitz’s genius has been to show that diversification can reduce volatility without sacrificing returns. Diversification is the financial version of the phrase “the whole is greater than the sum of its parts”.
An investor looking for high returns without volatility might not look to cryptocurrencies, like bitcoin, as they often plunge and soar. (Indeed, as Buttonwood was writing this column, that is exactly what bitcoin has done, falling 15% and then rebounding.) As the contribution it makes to the volatility of the overall portfolio – and that is foremost. a question of correlation between all the assets that compose it. An investor holding two weakly correlated or uncorrelated assets can rest more easily in the knowledge that if one plunges in value, the other might hold up.
Consider the mix of assets a sensible investor might hold: geographically diverse stock market indices; obligations; a listed real estate fund; and maybe a precious metal, like gold. The assets that produce the juiciest returns (stocks and real estate) also tend to move in the same direction at the same time. The correlation between stocks and bonds is low (around 0.2-0.3 over the past ten years), offering potential for diversification, but bonds have also tended to lag behind in terms of yield. Investors can reduce volatility by adding bonds, but they also tend to generate lower returns.
This is where bitcoin has an advantage. Cryptocurrency can be very volatile, but over its short lifespan it has also had high average returns. Importantly, it also tends to move independently from other assets: as of 2018, the correlation between bitcoin and stocks in all geographies is between 0.2 and 0.3. Over longer time horizons, it is even lower. Its correlation with real estate and bonds is also low. This makes it a great potential source of diversification.
This could explain its appeal to some large investors. Paul Tudor Jones, a hedge fund manager, said he aims to hold around 5% of his portfolio in bitcoin. This allocation seems reasonable in the context of a very diversified portfolio. In the four time periods over the past decade that Buttonwood randomly selected to test, an optimal wallet contained a 1-5% bitcoin allocation. It’s not just because cryptocurrencies have exploded: even if we choose a few particularly volatile years for bitcoin, say from January 2018 to December 2019 (when it fell sharply), a portfolio with an allocation of 1% to bitcoin was always a better risk. reward the characteristics that one without it.
Of course, not all of the calculations regarding which assets to choose are straightforward. Many investors are not only looking to do well with their investments, but also to do good: bitcoin is not environmentally friendly. In addition, in order to select a portfolio, an investor must gather relevant information about the possible behavior of the securities. Expected returns and future volatility are generally assessed by looking at the past performance of an asset. But this method has obvious flaws. Past performance is not always indicative of future returns. And the history of cryptocurrencies is short.
Although Mr Markowitz explained how investors should optimize asset choices, he wrote that “we haven’t considered the first step: forming relevant beliefs.” Return on investment in stocks is a share of company profits; bonds the risk-free rate plus the credit risk. It is not clear what is driving bitcoin’s returns other than speculation. It would be reasonable to believe that it might yield no return in the future. And many investors hold fierce philosophical beliefs about bitcoin, whether it’s salvation or damnation. Neither party will hold 1% of its assets there.
This article appeared in the Finance & economics section of the print edition under the title “Just add crypto”