Bitcoin and Portfolio Diversification
Diversification between assets classes can improve the risk-adjusted returns of your investment portfolio. In this article, we’ll see how portfolio diversification applies to bitcoin.
The usual disclaimer: none of this is investment advice. It’s just for information and illustration.
Modern Portfolio Theory
Harry Markowitz pioneered Modern Portfolio Theory (MPT) in 1952 when he published his Portfolio Selection Paper.
MPT shows the power of diversification by constructing “risk efficient portfolios” on the Efficient Frontier. These portfolios have the highest returns for given levels of risk:
The diagram shows the diversification benefits of mixing two different asset classes (in this case stocks and bonds). In this example, there are two types of portfolios:
- Risk efficient portfolios: Portfolios B to E shown along the green line. These portfolios provide the highest returns for each level of risk.
- Risk inefficient portfolios: All red dotted portfolios. These portfolios provide inferior returns for each level of risk.
Portfolio A is an example of a risk inefficient portfolio. It has a standard deviation of just under 10% but an inferior return to a portfolio that lies on the green line above with the same level of risk. By diversifying a bit into stocks, the overall portfolio risk goes down, and the expected returns go up.
The green line (excluding the bottom part with red dotted portfolios) is the efficient frontier; any portfolio that lies along this is risk efficient.
Diversification and correlation
Diversification works best when assets are uncorrelated. The returns of stocks and bonds don’t always go up (or down) at the same time. This is why many investors own a few asset classes in their portfolios.
If we add more uncorrelated asset classes to our investment portfolios, logic dictates that our portfolios would become more risk efficient. This is why I invest in different types of assets, including gold, private equity, mutual funds, and of course…digital assets…
Bitcoin and portfolio diversification
Bitcoin is massively volatile (risky) as a single investment. But since bitcoin’s returns are uncorrelated with traditional asset classes like stocks or bonds, it offers excellent diversification. A small allocation to bitcoin seems to have a fairly small impact on investment portfolio risk—while boosting returns over time.
In terms of Markowitz’s MPT, portfolio’s can become more risk efficient when a small allocation of bitcoin is added to them.
Backtest: adding bitcoin to a stock portfolio
To examine bitcoin’s diversification benefits, we can backtest the returns of four different portfolios:
- 100% Stocks
- 99% Stocks; 1% bitcoin
- 98% Stocks; 2% bitcoin
- 95% Stocks; 5% bitcoin
Here are the assumptions of the test:
- The S&P 500 Index represents stocks.
- The 3 bitcoin portfolios are rebalanced at the start of each month to their required weights.
- Taxes and trading costs are ignored.
Using data from Yahoo Finance, we can backtest each of the four portfolios over the last 8 years (1st September 2010 — 1st September 2018). The chart below shows the returns for each portfolio over this time:
We can break these results down further in the table below:
For the above table, green is good and red is bad. We can see from the numbers that adding bitcoin increased the returns of owning a simple S&P 500 US stock portfolio.
Total portfolio volatility goes up slightly as the bitcoin percentage allocations increase, but the portfolios become more risk efficient (meaning you get more return for a given level of risk).
We know this because the Sharpe ratio goes up with bitcoin allocation. Not bad when you consider bitcoin was down nearly 70% this year…
Jonathan Hobbs, CFA, is an author, entrepreneur and financial blogger. He is a Director of Ecstatus Capital. In his personal portfolio, he invests in stocks, mutual funds, startup companies, gold and digital assets.