Bitcoin for the investment mix: Why adding crypto can improve the risk-return profile of an investment portfolio
The chance of a return on a single investment is of course tempting, but investors should always keep an eye on the corresponding higher risk. Putting everything on one card can result in huge losses. It is not without reason that recognized economists repeatedly advise diversification in order to balance the portfolio’s risk / return ratios. Crypto-assets like bitcoin can be considered as a mix. Because they generally correlate less with traditional asset classes. They can thus contribute to a more crisis-proof portfolio.
Building wealth is not an easy game. Because a good portfolio is more than the sum of its parts. Economist and Nobel laureate Harry Markowitz sums this up in the following basic principle: “A good portfolio is more than a collection of good stocks and bonds. It is a balanced whole that protects the investor and offers opportunities for all eventualities. ” Decades later, this statement has not lost its significance. Markowitz’s portfolio theory still applies, according to which the investment must achieve the highest possible return for the investor at a risk that seems appropriate to him personally. A portfolio should therefore match both return opportunities and risks in the best possible way.
It succeeds, according to the acclaimed economist, when investors invest in different asset classes because wide diversification can reduce the risk of partial or total losses. We are therefore also looking for assets that correlate as little as possible with the core investments in the portfolio. The value of asset A should develop as independently as possible from the price of asset B. This reduces the volatility – and thus the risk – of the entire portfolio. Investors are also increasingly focusing on digital assets such as Bitcoin, because when it comes to diversification, cryptocurrencies play to one of their strengths.
Bitcoin shows low correlation to gold …
A well-thought-out portfolio usually has other different items in addition to liquidity reserves. For example, stocks, commodities such as gold, cryptocurrencies and bonds can be part of a balanced portfolio. Bitcoin especially plays trump when it comes to correlation with gold: According to data analyst Arcane Research, the cryptocurrency has the lowest 30-day correlation since 2019 with a value of minus 0.45 in April 2022. For rating: A value of 0 means that there is no connection. The diversification effect is then very high; a value of 1, on the other hand, signals a complete correlation, there is no diversification effect. The lower the value, the more suitable the asset for portfolio diversification. Typically, the correlation between different asset classes is between 0.5 and 0.9. In the case of bitcoin and gold, there is a negative correlation. This means that both assets are moving in almost opposite directions relative to their price development. Investors can take advantage of this effect to reduce the level of risk in their portfolio without compromising returns.
… but currently a reliance on technology stocks
It is true that the correlation between digital assets like Bitcoin and gold is favorable for the portfolio mix. However, this should not distract from the fact that Bitcoin has been much more in line with the performance of other asset classes in recent months. The correlation with especially tech stocks has risen sharply in the wake of the corona pandemic. Bitcoin’s 90-day correlation with the S&P 500 index hit a record high of 0.58 in April, while the correlation with the technology-heavy Nasdaq index was even higher at 0.70. Although no one can predict the future, investors should be aware of: Especially in times of extreme macroeconomic situations? – such as the current high global inflation? – the synchronization of what are actually very different asset classes can increase.
If, on the other hand, the turbulence in the capital markets subsides, the correlation can also be reduced to pre-crisis levels. Because before the start of the corona pandemic, the Bitcoin correlation to the Nasdaq was still at a value of 0? – so there was no correlation between the crypto asset and the stock index. It is not possible to predict whether the dependencies will return to pre-crisis levels. However, investors should still keep an eye on correlation values in the longer term, because the diversification effect often only occurs after several months. In the long run, digital assets can certainly reduce the overall risk of losses in a portfolio despite their own relatively high volatility.
Sharpe ratios: Bitcoin shows above-average risk-reward ratios
The wider the risk spread in the portfolio, the higher the protection against losses is usually. What diversification does not achieve, however, is that it cannot in itself increase returns. It is true that cryptocurrencies are very volatile and therefore only suitable for investors looking for a return to add to their portfolios on a relatively small scale. But unlike other asset classes, cryptocurrencies like bitcoin and ether have already had quite an impressive risk-return ratio. The Sharpe ratio is one of the most popular indicators used by investors to determine risk-adjusted returns. A high Sharpe Ratio indicates that the respective asset was able to achieve high performance with relatively low risk.
The higher the Sharpe ratio, the better the risk-return ratio. For classification: A Sharpe ratio greater than 1 signals an above-average return on the asset relative to the risk taken. Compared to other asset classes, Bitcoin performs better with a current Sharpe ratio of 1.81. Assets such as US equities (1.58), gold (1.46) and bonds (0.54) have poorer risk / return balances. Sharpe Ratio signals that a portfolio that invests in cryptocurrencies such as Bitcoin could potentially offer a better risk-adjusted return than portfolios without cryptocurrencies.
Digital assets can advantageously expand the portfolio
Digital assets are a dynamic new asset class that is particularly well-suited for portfolio diversification due to their sometimes low correlation with other asset classes. In small amounts, cryptocurrencies like bitcoin can increase the chances of returns without at the same time straining the risk profile of the investment. However, it should be noted that although Bitcoin offers a good risk-return ratio, conservative investors should initially observe digital assets from the sidelines due to their volatility and the current macroeconomic related correlation to traditional assets. On the other hand, more risky investors may keep an eye on cryptocurrencies, as the positive effects of rising portfolio returns may outweigh the negative effects of higher volatility.