As a professional investor, you wouldn’t be new to the importance of diversification in investments.
By spreading one’s capital across multiple asset types, a well-diversified portfolio allows you to gain exposure to high-growth vehicles while reducing the risk of putting all your eggs in one basket.
Although not a traditional asset class like stocks or bonds, cryptocurrency is worthy of serious consideration as part of your portfolio diversification strategy.
The crypto market size now stands at US$2 trillion (as of September 2021), making it far too large for professional investors to ignore. And with Bitcoin taking the lion’s share of the market, it is naturally the first port of call for those looking to diversify.
Below, we explain how adding Bitcoin to your investment portfolio can lower risk and yield potentially higher returns.
Why diversify your portfolio with Bitcoin?
Ever since it got investors’ attention in 2017, Bitcoin has enjoyed a meteoric (if bumpy) rise.
Looking at its price of about US$61,000 (as of October 29, 2021), it’s hard to imagine that one BTC cost just US$1,000 at the start of 2017. Despite its dizzying swings in prices, Bitcoin has outperformed all traditional assets, including high-growth tech stocks like Amazon and Google.
Thus, allocating a small portion of one’s investment portfolio to Bitcoin could result in potentially higher returns than investing in conventional investment vehicles.
But the more compelling case for diversifying your portfolio with Bitcoin is its low correlation with traditional assets, as this February 2021 Bloomberg report shows.
Correlation measures how much any given asset mirrors another in terms of performance. Two perfectly correlated assets would have a correlation score of 1.0, meaning that if one falls by 5%, the other would also fall by 5%, and vice versa.
According to Bloomberg, the correlation between Bitcoin and the S&P 500 index was only 0.21. Given this, we can expect Bitcoin prices to behave differently from S&P 500 stocks.
Holding investments with low or negative correlation to one another is an essential component of Modern Portfolio Theory. Regardless of whether Bitcoin ultimately delivers higher results, research has shown that its low correlation with other assets allows investors to achieve diversification and reduce the risk of losses, ultimately improving their portfolios’ ratio of return to volatility.
What about other cryptocurrencies?
What’s described above also applies to tokens other than Bitcoin. As a whole, the cryptocurrency market has very low correlation to traditional assets like stocks, bonds and gold.
Apart from diversifying your traditional portfolio with Bitcoin, you might wonder if it’s a good idea to spread out risks even more by also investing in other cryptocurrencies, a.k.a. altcoins.
On the face of it, investing in multiple tokens seems like a good way to limit the risk of an extreme outcome — for example, in the event that any cryptocurrency fails completely and goes to zero.
However, Bitcoin is highly correlated with altcoins. According to the website CryptoWatch, the correlation between Bitcoin and Ethereum is 0.85, while that of Bitcoin and Ripple’s XRP is 0.80. Both are very close to the “perfect score” of 1.0.
If your goal is to diversify your crypto investments, it makes sense to select those with a lower correlation score, like Cardano’s 0.64. Of course, these statistics are not set in stone, so investors would need to actively monitor their crypto holdings.
At the end of the day, given that most utility tokens are positively correlated, the benefits of a multi-cryptocurrency portfolio may be somewhat limited.
How much of your portfolio should you allocate to Bitcoin?
Although Bitcoin is a sound way to diversify a traditional investment portfolio, its volatility makes asset allocation a bit of a balancing act.
Allocate too little to Bitcoin, and you may not enjoy the full benefits of diversification. But allocate too much, and your portfolio can become too high-risk for comfort, especially given Bitcoin’s short-term price swings.
The amount to allocate to Bitcoin (or cryptocurrencies in general) should reflect you or your clients’ risk tolerance.
At the most conservative level, allocating 1% of your total portfolio to Bitcoin could increase returns with minimal impact on overall volatility.
But those who are able to tolerate more volatility can go up to 5%, which hedge fund manager Paul Tudor Jones says is the perfect percentage (watch video).
Professional investors who are able to manage portfolios actively can aim for the upper end of the scale, i.e. 5%, in order to generate better returns. Do note that this would also entail watching the market closely and adjusting for potential short-term losses.
What if your Bitcoin holdings go beyond 5%?
While we’re on the topic of active management, one important task to factor into your diversification strategy is periodic rebalancing.
Rebalancing is an essential part of maintaining any well-diversified portfolio. But when your portfolio includes assets as fast-moving as cryptocurrencies, it becomes even more of a priority.
Because of Bitcoin’s price volatility, investors may find that their original investment can rapidly grow and exceed the original target allocation. For example, your Bitcoin holdings, once 5% of your total net worth, can quickly soar to 10% in months.
Left uncorrected, this can expose the investment portfolio to concentration risk. In this case, your outsized Bitcoin weightage may increase risk of losses in the event of sudden fluctuations in Bitcoin’s price (which happens a lot!).
It’s important for professional investors to adjust their Bitcoin allocation every quarter or every six months at the very least. You can bring your investment portfolio back into balance by selling off the excess Bitcoin and re-allocating the earnings to other assets.
Increase returns and reduce risk with Bitcoin
The idea of diversifying one’s portfolio with a volatile asset like Bitcoin may seem counterintuitive at first glance. But the economics, as we’ve shown, are sound. Furthermore, the impact of its fluctuations can be managed by limiting holdings to a small percentage and with periodic rebalancing.
With such measures in place, Bitcoin should get due consideration as part of every professional investor’s diversification strategy.