Daily Brief - Yes, Bitcoin can mitigate your portfolio risk (Oct 26, 2021)

Are you crazy? If you’re looking to reduce your portfolio risk, why would you ever include cryptocurrencies? Recent history shows that - for all the talk of institutional acceptance - they can plunge and soar in value at a moment’s notice. And from a single tweet. If you want a safe portfolio, stay as far away from this niche cult as possible.

Right? Wrong.

It’s precisely the “niche” aspect of bitcoin that gives it the risk-mitigating properties suited for a bold trader with concentrated positions. A recent column in The Economist neatly explains the counter-intuitive insight. The key is to realize that it’s not necessarily a security’s own volatility that is important to an investor so much as the contribution it makes to the volatility of the overall portfolio.

Instead, the key to such a contribution is the correlation between all of the assets within it. Two assets whose prices generally move completely independently of each other can bring more peace of mind to the trader knowing that if one plunges in value the other might hold its ground.

This insight earned Harry Markowitz a Nobel prize in economics back in 1990. He was able to demonstrate that diversification can reduce volatility without sacrificing returns.

Incidentally, this is one aspect of what makes risk-parity portfolios so popular: over short periods of time, bonds and stocks move in the opposite direction (on a risk-off day, bonds will generally trade higher).

In contrast to bonds, however, bitcoin has the potential for much higher returns. The cryptocurrency has been incredibly volatile but, for those who stuck with it (or traded it well) also delivered high returns. Most importantly, as The Economist article highlights, it moves independently of other assets. The correlation between bitcoin and stocks of all geographies has been between 0.2-0.3 since 2018. This is comparable to that between stocks and bonds. Over longer time horizons it is even weaker. This makes it an excellent potential source of diversification.

It’s these - rather dull - calculations, rather than the fad mania, that have made it compelling for established institutional investors to buy into bitcoin. Jamie Dimon may be anti-bitcoin but his institution has done the numbers and, well, quietly recommended bitcoin to its clients.